Should central banks burst bubbles? Some microeconomic issues

Abstract

Anti-bubble policy is examined in a finite-horizon 'greater fool' bubble model, with rational agents, asymmetric information and short-sales constraints. This permits the use of standard tools of welfare economics to analyse bubble policies. Policy is modelled as deflating overpriced assets by revealing information about this overpricing. If the central bank is following such a policy, then the market interprets inaction as an implicit endorsement of asset prices, which raises these prices. Also, the central bank can deflate overpriced assets even if it has no informational advantage over any investors about this overpricing. However, unless it has such an informational advantage, a bubble-bursting rule may only make things worse.