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Expands the idea that rational arbitrage not only may be limited in bringing about market efficiency but may actually generate price bubbles and make markets less efficient. It begins by presenting an alternative view of price patterns observed in the data on security returns—one based on feedback trading. It also describes the interactions of noise traders and arbitrageurs and shows that in cases in which arbitrageurs trade in anticipation of noise trader demand, they move the price away from rather than towards fundamental values.

This chapter imposes a zero lower bound (ZLB) on nominal interest rates, as a constraint on the actions of policymakers attempting to deal with a developing asset-price bubble. It provides the optimal monetary policy recommendations of activist and skeptical policymakers, through time, in the presence of an asset-price bubble. It concentrates on the period in which the bubble survives and grows. For an economy with lower responsiveness, it is observed that the effect of the ZLB on an activist policymaker's recommendations is correspondingly greater, when faced with an exogenous bubble. The data show that fears of encountering the ZLB should not be overstated, unless the neutral nominal interest rate in the economy is very low. Furthermore, there are three forms of “insurance” that a policymaker can take out against the risk of encountering the ZLB due to the future bursting of an asset-price bubble.

This chapter concludes the book and discusses some hotly debated issues in crises prevention, with special emphasis on the role of assets prices movements and the optimal choice of an exchange rate regime.

This chapter examines whether or not monetary policy should respond to asset price bubbles. More specifically, it asks how central banks respond while an asset bubble is growing and how they respond after the bubble bursts. It begins with a general overview of asset bubbles that supports the existence of the real and financial sectors of an economy before discussing how the bursting of asset price bubbles may cause financial instability that often adversely affects the real sector of an economy. It then describes the normative vs. positive responses of a central bank to asset price bubbles, along with the concept of macroprudential regulation as an approach for leaning against asset bubbles. It argues that the high costs associated with the 2007–2009 financial crisis undermined the so-called Jackson Hole Consensus and that the new central bank policy paradigm appears to have shifted toward “leaning against bubbles”.

This chapter comments on the paper, “Churning Bubbles,” by Franklin Allen and Gary Gorton. In their paper, Allen and Gorton examine whether stock prices are determined by fundamentals or whether “bubbles” can exist. The chapter examines the state of theoretical models of asset price bubbles and considers the lessons learned from the financial crisis of 2007–2009. It also looks at the gap between the theoretical work on asset bubbles and the apparent change in views coming out of the financial crisis about the appropriate policy response. It suggests that theoretical models of bubbles have failed to adequately address welfare considerations and thus are unable to offer convincing analytical guidance to central banks as to whether an economy is better off with or without a bubble.

This chapter examines the impact of the international financial crisis of the late 2000s on Asia and the Pacific, with particular emphasis on monetary policy challenges arising from negative asset price bubbles. It begins with an overview of negative asset price bubbles and the international financial crisis in Asia and the Pacific. It then argues that being aware of the causes of past crises was not sufficient to protect the Asia-Pacific economies from the more recent crisis. It also considers the view that the global financial system needs to be strengthened and that the spillovers of the international financial crisis from the West to Asia and the Pacific presented daunting policy challenges for central banks in the region.

This chapter examines the volatility of asset price bubbles and its implications for monetary policy. It first considers how asset prices interact with the real economy before expanding the financial accelerator model by incorporating exogenous bubbles in asset prices. It then explores how an asset bubble affects real activity via the wealth effect on consumption and firms' financial decisions via appreciations of assets on the balance sheet. Using stochastic simulations, it suggests that central banks should view price stability and financial stability as highly complementary and that central bank policies should not respond to changes in asset prices, except insofar as they signal changes in expected goods and services inflation.

This chapter reviews research on the origins of the financial crisis of 2008–2009, highlights the key events that triggered a financial panic in September 2008, and summarizes the extraordinary policy actions the United States (US) has taken to ameliorate the crisis. It discusses the proximate causes of the crisis, including the characteristics and growth of the subprime mortgage market, and the distorted incentives and flawed regulatory structure surrounding the secondary market for mortgage-backed securities. It also assesses the role of more fundamental macroeconomic determinants of the bubble in US asset prices, most notably low global interest rates attributed to either loose monetary policy or excess global saving

Has rising income inequality or rising household debt or a housing price bubble played a role in serious economic decline in the past? Did a rising average propensity to consume, and thus a falling rate of saving, warn of unsustainable consumption leading to a serious economic decline before the present recession? Those are the questions considered in this chapter, and they all receive the same answer: yes.

This chapter comments on the paper “Monetary Policy and Asset Price Volatility,” by Ben Bernanke and Mark Gertler. In their paper, Bernanke and Gertler examine the volatility of asset price bubbles and its implications for monetary policy. The chapter analyzes the Bernanke and Gertler results in view of the financial crisis of the late 2000s. It presents two lessons from the financial crisis that challenge the Gertler-Bernanke results. First, macroeconomic stability and price stability do not guarantee financial stability. Second, because the bursting of an asset bubble can adversely affect the real macroeconomy, the central banks' financial stability mandate should not be taken lightly. The chapter discusses whether interest rate policy or macroprudential supervision and regulation should be used to address the bubble.

This chapter presents a behavioral-based model for studying asset price bubbles and trading volume based on heterogeneous beliefs generated by agents' overconfidence. It describes the explicit links between the model's parameter values, such as trading cost and information, and the behavior of equilibrium prices and trading volume. The model can be used to analyze speculative trading as well as the links between asset prices, trading volume, and price volatility.

This chapter examines how excesses in the global housing and mortgage markets contributed to the financial crisis of 2008. It begins by considering the enthusiasm for real estate worldwide in the early days of the new millennium, along with rise in house prices coupled with the growth of mortgage debt. It then discusses the impact of housing wealth on consumption and the dramatic rise in subprime loans, along with the role of incentives and investment banks in the emergence of problems in the mortgage market. It also analyzes how regulation and especially the US government's support for mortgage lending precipitated the global financial crash. The chapter concludes by focusing on the persistence of asset price bubbles and their link to arbitrage.

This book reexamines the profession's understanding of asset price bubbles in the wake of the major financial crisis of 2007–2009. It is the result of the conference “New Perspectives on Asset Price Bubbles: Theory, Evidence and Policy,” held at Loyola University Chicago on April 8, 2011. Five previously published classic papers that were thought to represent the orthodox thinking about asset bubbles prior to the 2007–2009 financial crisis were selected by the editors. As the basis for the conference, five distinguished economists were then invited to write original papers evaluating the accuracy of the analysis in the “classic” papers. This book includes both the five classic papers and the five papers presented at the conference evaluating the original contributions. By way of introduction, this chapter discusses the main strands of inquiry on asset bubbles in both the previously published classic papers and the responding new papers. Topics range from stock prices and asset prices to monetary policy, leverage as a major cause of bubbles, and the financial instability that results from an asset bubble bursting.

High and volatile prices of major commodities have generated a wide array of analyses and policy prescriptions, including influential studies identifying price bubbles in periods of high volatility. Here we consider a model of the market for a storable commodity in which price expectations are unbounded. We derive its implications for price time series and empirical tests of price behavior. In this model commodity price is equal to marginal consumption value, and hence bubbles as defined in financial economics cannot occur. However the model generates episodes of price runs that could be characterized as “explosive” and might seem to be bubble-like. At sufficiently long holding periods, a price path can yield average returns consistent with mean reversion, even though the long run expectation of price is infinite.

A revolution in global finance following bank liberalisation in the 1980s and the invention of new methods of bundling debts into bonds — through the process of securitization — enabled banks to separate the origination of mortgages from the long-term investment of these debts. In this new global financial system, a tsunami of capital was created that washed across the planet, creating a surge in house prices almost everywhere, especially in the house price bubble of 2000–5. There were, however, many variations in the institutional structure of mortgage systems, so the economic and social outcomes of peoples' access to new forms of lending at a national level were very varied. Societies with open/liberal markets benefited most as innumerable new mortgage products connected households to these global flows of capital. But even some of the social market economies were impacted by this new era of global finance, and integrated rental markets came under pressure. The process of housing equity withdrawal enabled homeowners to access accruing property values in ways previously impossible.

This chapter examines whether the stock market occasionally overvalues firms and these asset price bubbles lead to overinvestment, paying particular attention to the distortive impact of bubbles on efficient capital allocation regardless of whether they burst or not. Using a revealed preference approach that relies on the investment decisions of firms, combined with investment theory, it estimates the discount rates actually used by managers of U.S. firms. It presents empirical evidence to support the theory that firms with high stock prices and poor investment opportunities should have discount rates consistently below the market rate, consistent with a misallocation of resources during bubbles.

This paper examines the interwar housing cycle in comparison to what transpired in the United States between 2001 and 2012. The 1920s experienced a boom in construction and prolonged retardation in building in the 1930s, with a swing in residential construction’s share of GDP and absolute volume, which was larger than occurred in the 2000s. In contrast, there was relatively little sustained movement in the real price of housing between 1919 and 1941. The upward and downward price movements were modest, certainly in comparison with more recent experience. The paper documents the higher degree of housing leverage in 2001-2012 and a rate of foreclosure on residential housing post-2006 that is likely higher than the rate endured during the 1930s. It concludes that balance sheet problems arising from the residential housing boom posed greater obstacles to recovery in the more recent period than they did in the interwar period.

This chapter comments on the paper Overconfidence and Speculative Bubbles, by José A. Scheinkman and Wei Xiong. In their paper, Scheinkman and Xiong propose a behavioral-based model for studying asset price bubbles and trading volume based on heterogeneous beliefs generated by agents' overconfidence. The chapter presents a detailed overview of behavioral finance from the perspective of asset bubbles and challenges the notion that pure fundamentals and rationality drive decision-making and pricing. It suggests that behavioral issues must be more fully incorporated into decision-making models and concludes by discussing asset price bubbles in view of the financial crisis of the late 2000s.

This chapter suggests that the large literature on asset price bubbles has not incorporated the results from control theory from the 1960s and the rational expectations literature from the 1970s, and that it would be a mistake for the government to attempt to influence, through direct market intervention, an asset price suspected of displaying a bubble. It also argues that the problem with a bubble is not the bubble per se but the accumulation of bubble-related assets in leveraged portfolios. Finally, it discusses three key reforms to strengthen the banking system.