In this paper we explore the optimal policy reaction to boom-bust cycles in asset prices. Bordo and Jeanne (2002a, b) point to the risks of a reactive strategy that only mitigates the consequences of a crisis if and when it occurs. Acting pre-emptively by rigorously counteracting the build-up of the crisis scenario may be superior in welfare terms. We show that even a purely reactive monetary policy must involve an ex ante response to a possible asset price crash. The reason, however, is not the attempt to avoid real and financial disruption but to react optimally to changes in the private sector's expectations. Furthermore, we find that the welfare losses of a reactive strategy increase when forward-looking expectations are taken into account, while the welfare implications of a proactive strategy do not change.
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Summary
Recently, convincing evidence has been presented that the recession in the wake of the recent financial crisis resulted primarily from an overly levered housing sector that was forced to deleverage and cut consumption spending when faced with collapsing housing prices. Following this interpretation it is argued that, as opposed to the consensus view on monetary policy in the vicinity of the ZLB, optimal monetary policy may involve an interest rate increase if the ZLB threatens to become a binding constraint in the aftermath of an asset price bust. This result delivers arguments to advocate a— in the previous literature less favored— pre-emptive tightening policy in an asset price boom.
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