Monetary Policy and Asset Price Bubbles: A Laboratory Experiment

Here.

Advocates of a Leaning-Against-the-Wind monetary policy have claimed that such a policy can moderate asset price bubbles. On the other hand, there are compelling theoretical arguments that the policy would have the opposite effect. We study the effect of monetary policy on asset prices in a laboratory experiment with an overlapping generations structure. Participants in the role of the young generation allocate their endowment between two investments: a risky asset and a one-period riskless bond. The risky asset pays no dividend and thus capital gains are its only source of value. Consequently, its price is a pure bubble. We study how variations in the interest rate a§ect the evolution of the bubble in an experiment with three treatments. One treatment has a Öxed low interest rate, another a Öxed high interest rate, and the third has a Leaning-Againstthe-Wind interest rate policy in e§ect. We observe that the bubble increases (decreases) when interest rates are lower (higher) in the period of a policy change. However, the opposite e§ect is observed in the following period, when higher (lower) interest rates are associated with greater (smaller) bubble growth. Direct measurement of expectations reveals a Trend-Following component. 



Jordi Galí
Giovanni Giusti
Charles N. Noussair