On Interest Rate Policy and Asset Bubbles

In a provocative paper, Gali (2014), showed that a policymaker who raises interest rates because of concerns about a bubble will paradoxically make the bubble bigger. In this paper, we argue Gali's framework abstracts from the possibility that a policymaker who raises rates might crowd out resources that would have otherwise been spent on the bubble. We show that when we modify Gali's model to allow for this possibility, interventions that lead to higher interest rates can dampen bubbles. However, even if raising rates effectively dampens bubbles, such an intervention is not Pareto improving in the modified version of Gali's model we analyze. We then show that if we modify the model so that it can generate the type of credit-driven bubbles policymakers worry about, raising rates may still be effective against bubbles, and that there may be scope for such interventions to make society better off.