Monetary Policy and Asset Price Bubbles: A Laboratory Experiment

• Authors: Jordi Galí.
• BSE Working Paper: 112242 | June 20

Leaning-against the-wind (LAW) policies, whereby interest rates are raised in the face of a growing asset price bubble, are often advocated as a means of dampening such bubbles. On the other hand, there are theoretical arguments suggesting that such a policy could have the opposite effect (Galí, 2014). We study the effect of monetary policy on asset price bubbles in a laboratory experiment with an overlapping generations structure. Participants in the role of the young generation allocate their endowment between two investments: a risky asset and a one-period riskless bond. The risky asset pays no dividend and thus the possibility of selling it to the next generation is its only source of value. Consequently, its price is a pure bubble. We study how variations in the interest rate affect the evolution of the bubble in an experiment with three treatments. One treatment has a fixed low interest rate, another a fixed high interest rate, and the third has a LAW interest rate policy in place. We observe that the bubble increases (decreases) when interest rates are lower (higher) in the period of a policy change. However, the opposite effect is observed in the following period, when higher (lower) interest rates are associated with greater (smaller) bubble growth. Direct measurement of expectations reveals that traders expect prices to follow previous trends and tend to correct for prior errors in their predictions.