To Lean or not to Lean against An Asset Price Bubble? Empirical Evidence

After the Global Financial Crisis of 2007After the Global Financial Crisis of 2007-09, economists are reconsidering the appropriate role of monetary policy towards equity bubbles. This paper contributes to these deliberations by estimating the response of the stock market to a monetary policy tightening by using a Bayesian time-varying VAR model. By introducing the cyclically adjusted Price/Earnings ratio (CAPE), we propose a method that estimates its fundamental and bubble components. We find that asset prices will initially fall and eventually rise again but without the risk of feeding the bubble. Counterfactual policy experiments provide additional evidence that monetary policy can lean against equity and housing prices. -09, economists are reconsidering the appropriate role of monetary policy towards equity bubbles. This paper contributes to these deliberations by estimating the response of the stock market to a monetary policy tightening by using a Bayesian time-varying VAR model. By introducing the cyclically adjusted Price/Earnings ratio (CAPE), we propose a method that estimates its fundamental and bubble components. We find that asset prices will initially fall and eventually rise again but without the risk of feeding the bubble. Counterfactual policy experiments provide additional evidence that monetary policy can lean against equity and housing prices