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Working paper

Should Monetary Authorities Prick Asset Price Bubbles? Evidence from a New Keynesian Model with an Agent-Based Financial Market

Vasilenko A. S.
We develop the approach based on the synthesis of New Keynesian macroeconomics and agentbased models, and build a model, allowing for the incorporation of behavioral and speculative factors in financial markets in a New Keynesian model with a financial accelerator, `a la Bernanke et al. (1999). Using our model, we study the optimal strategy of central banks in pricking asset price bubbles for the maximization of social welfare and preserving financial stability. Our results show that pricking asset price bubbles can be a policy that enhances social welfare, and reduces the volatility of output and inflation; especially, in the cases when asset price bubbles are caused by credit expansion, or when the central bank conducts effective information policy, for example, effective verbal interventions. We also argue that pricking asset price bubbles with the lack of the effectiveness of information policy, only by raising the interest rate, leads to negative consequences to social welfare and financial stability.