Should central banks respond to asset price bubbles? This paper explores this monetary policy question in a hypothetical economy subject to asset price bubbles. Despite the highly stylized structure of the model, the results reveal several practical monetary policy lessons. First, a monetary authority should generally respond to asset prices as long as asset prices contain reliable information about inflation and output. Second, this finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. Third, a monetary authority’s desire to respond to asset prices falls dramatically as its preference to smooth interest rates rises. Finally, a monetary authority should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices. 

JEL classification: E5, G1 

Keywords: Monetary policy, asset prices 

Andrew J. Filardo is an assistant vice president and economist at the Federal Reserve Bank of Kansas City. The author would like to thank V.V. Chari, Craig Hakkio, Harvey Rosenblum, Eric Rosengren, seminar participants at the Federal Reserve Bank of Kansas City, and participants in the session on Asset Price Bubbles at the 2001 Western Economic Association conference for helpful comments, and Hank Hui for valuable research assistance. The views expressed in this paper are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Filardo E-mail: andrew.j.filardo@kc.frb.org