Monetary Policy and Herd Behavior: Leaning Against Bubbles

Olivier Loisel, Aude Pommeret, Franck Portier
2012 Social Science Research Network  
We study the role of monetary policy when asset-price bubbles may form due to herd behavior in investment in an asset whose return is uncertain. To that aim, we build a simple generalequilibrium model whose agents are households, entrepreneurs, and a central bank. Entrepreneurs receive private signals about the productivity of the new technology and borrow from households to publicly invest in the old or the new technology. The three main results of the paper are that bubbles (informational
more » ... (informational cascades) can occur in this general equilibrium setting; that the central bank can detect them even though it has directly access to less information than the investors; and that the central bank can eliminate bubbles by manipulating the interest rate. Indeed, monetary policy, by affecting the investors' cost of resources, can make them invest in the new technology if and only if they receive an encouraging private signal about its productivity. In doing so, it makes their investment decision reveal their private signal, and therefore prevents herd behavior and the asset-price bubble. We also show that such a "leaning against the wind" monetary policy, contingent on the central bank's information set, may be preferable to laisser-faire, in terms of ex ante welfare.
doi:10.2139/ssrn.2192466 fatcat:v4wun3fnwnd7xhzfnqvxa5ilra