WP Global Economy 2019.05.10
The large fluctuations of asset prices in financial crises are modeled as creditdriven bubbles, where agency problems in the banking sector raise the asset prices to unsustainable levels. The peak of a bubble and the timing of its collapse can be predictable because the bubble collapses when the price hits an endogenous threshold that is determined by structural parameters. Tighter monetary policy can dampen the size of the bubble, whereas tighter prudential regulations that cause credit rationing may exacerbate the bubble. Our theory recommends leaning against the bubbly wind, rather than screening the borrowers, as a stabilization policy.