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Should Central Banks Burst Bubbles?

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Author Info
John Conlon (University of Mississippi)

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Abstract

Policy towards speculative bubbles is examined in a model of a finite horizon 'greater fool' bubble, with rational agents, asymmetric information and short-sales constraints. This model permits the use of standard tools of comparative dynamics and welfare economics to analyze bubble policies. Government policy is modeled as deflating overpriced assets by revealing information about whether or not the asset is overpriced. It is shown that such a policy tends to improve welfare if it protects less-informed buyers from 'bad' sellers, who know the asset is overpriced. However, if policy deflates prices only in 'strong bubbles,', where all private agents know the asset is overpriced, this tends to reduce welfare. This is because, in those states where the central bank turns out not to deflate prices, bad sellers become more confident of selling the asset. That is, bubble bursting protects bad sellers from each other, which, in turn, can exacerbate the lemons problem in states where the asset is valuable.

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Paper provided by EconWPA in its series Game Theory and Information with number 0508007.

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Length: 46 pages
Date of creation: 12 Aug 2005
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Handle: RePEc:wpa:wuwpga:0508007

Note: Type of Document - pdf; pages: 46
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Related research
Keywords: Bubbles; Asymmetric Information; Policy;

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  1. Kai, Guo & Conlon, John R., 2007. "Why Bubble-Bursting Is Unpredictable: Welfare Effects Of Anti-Bubble Policy When Central Banks Make Mistakes," MPRA Paper 5927, University Library of Munich, Germany. [Downloadable!]
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