Stock market bubbles, time-varying risk premia, and monetary policy: Should the Fed respond to asset price fluctuations

There is an ongoing debate on whether monetary policy should react to asset price bubbles. In this dissertation we outline the current state of the debate and consider whether monetary policy should react or not and if so whether it should react moderately or aggressively. One key finding is that there is a large, time-varying risk premium associated with contractionary monetary policy. This implies that using contractionary monetary policy to pop a speculative bubble would increase the risk premium on assets like stocks, which are exposed to contractionary monetary policy. This in turn implies that an attempt to pop a bubble would not only affect the bubble term but also, by increasing risk premia, lower the fundamental value of stocks. In other words, an attempt to use monetary policy to pop a speculative bubble would cause stock prices to fall further than they would if the bubble popped on its own. This evidence indicates that it would be unwise to use monetary policy to pop speculative bubbles. This dissertation also considers four famous asset price bubbles: the U.S. stock market crash of the 1920s; the bursting of the Japanese equity and real estate bubble in the 1980s, the popping of the East Asian bubble of the 1990s and the U.S. stock market bubble of the late 1990s Analyzing these episodes indicates that using preemptive monetary policy to burst a bubble would be worse than allowing the bubble to pop on its own and then using expansionary monetary policy to contain the fallout. One important lesson from the narrative section is that a sound, well-regulated banking system can limit the damage caused by a bursting asset price bubble.