Optimal Macroprudential Policy and Asset Price Bubbles

IMF Working Papers, August 30, 2019

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An asset bubble relaxes collateral constraints and increases borrowing by credit-constrained agents.
As the bubble deflates when constraints start binding, it amplifies downturns.
Macroprudential policy should optimally respond to building asset price bubbles non-monotonically depending on the underlying level of indebtedness.
- If the level of debt is moderate, policy should accommodate the bubble to reduce the incidence of a binding collateral constraint.
- If debt is elevated, policy should lean against the bubble more aggressively to mitigate the pecuniary externalities from a deflating bubble when constraints bind.
Evidence and mechanisms are shown both analytically and quantitatively.

Adopt a state-dependent macroprudential stance that conditions the response to asset price bubbles on the prevailing level of indebtedness.
When indebtedness is moderate:
- Accommodate asset price increases to lessen the chance that collateral constraints become binding.
When indebtedness is elevated:
- Lean more aggressively against asset price bubbles to reduce the amplification of downturns when bubbles deflate and constraints bind.

Subjects covered: Asset bubbles, Asset prices, Collateral, Consumption, Credit, Financial crises, Financial institutions, Financial markets, Money, National accounts, Prices, Stock markets
Keywords: Asset bubbles, asset price bubble, asset price overvaluation, Asset prices, borrowing constraint, bubble bursting, bubble component, Collateral, collateral constraint, Collateral constraints, Consumption, Credit, credit imbalance, deflating bubble, equilibrium asset pricing, Global, macroprudential regulation, marginal utility, optimal policy, rational bubbles, real asset, stock market bubble, Stock markets, transition probability, WP