Crashes and bubbles, that lead to instability, and volatile dynamics of the economy, have been the subject of hot debate, in the macroeconomic literature for a long time. The global financial crisis of 2008 – 2009, and the recent bubble on the stock market in China only, have only increased the interest in these phenomena, and stress the existence of drawbacks in the existing methodologies of macroeconomic analysis, including issues that relate to the necessary reaction of regulatory authorities, onwith financial bubbles.
One stream of research, whichose popularity has significantly increased, after the global financial crisis of 2008 – 2009, is the development of agent-based macroeconomics, that is based on heterogeneous interacting agent, and bounded rationality. Many agent-based models, are built using these features, which successfully explain the dynamics of business cycles (For example, Gaffeo et al. (2007), Russo et al. (2007), Delli Gatti et al. (2010), Dosi et al. (2010), Dosi et al. (2013), Ricetti et al. (2013). Dilaver, Jump, and Levine (2006), presents the detailed literature review of agent based macroeconomic models.). Our paper relates to another similar growing field, that develops behavioral, New Keynesian models, which incorporate agent-based models in New Keynesian models. Usually such models consist of two parts: the real sector is constructed using a New Keynesian Macroeconomic (NKM) model, while the financial market is set through an agent-based model. Our model differs from the previous literature in this field, in complexity, of the real sector, and the financial market. This complication of the model, allows us to receive a new evidence, in another large field of the literature, that studies the necessary response of monetary policy on asset price bubbles.
The hot debate about the necessary response of monetary policy on asset price bubbles among policy makers, and academic professors, is known as the “clean” versus “lean” debate. Following the “clean” approach, cCentral bBanks should not respond to asset-price bubbles, before the bubble bursts, above the necessary reaction for the stabilization of inflation and employment, andbut just clean up the consequences of the bubble. This approach may be more preferable for monetary policy, because of several possible reasons: generally, bubbles are hard to detect; a bubble may exist only in a small market; the rising of interest rates may not efficiently affect bubbles; or sometimes it may cause the bubble to burst more severely. The “clean” approach prevailed winth the cCentral bBanks, and academia, before the global financial crisis of 2008 – 2009. According to another point of view, –with the “lean” approach, cCentral bBanks should provide monetary policy, that leans against asset-price bubbles, and leads to the increasing of interest rates. After the global financial crisis, the “lean” approach has become preferable, and nowadays the focus, from the question, ash tould cwhether Central bBanks should respond on asset-price bubbles or not, has been changed ton the question, how should cCentral bBanks respond on asset-price bubbles,. iIn which cases they, should they actively respond,. aAnd which strategy of the reaction its ist better to use (for more detailed discussion of the “clean” versus “lean” debate see, for example, Mishkin (2011) or Brunnermeier and Schnabel (2015).
At the early stage of a bubble, it is difficult to identify the bubble, because at this stage, misalignment is not yet large yet, so monetary policy usually can start affecting the bubble, only after the bubble has already grown to a someubstantial size. In our paper, we study the possibility for monetary policy to prick asset price bubbles, for the increasinge of social welfare, by raising the interest rate in such situation,s. wWhen the bubble exists, but not in the early stage, market asset prices differ significantly from fundamental asset prices, and the cCentral bBank suspects about the existiengce of the bubble, as well as other economic agents. Surprisingly, there is thea lack of the papers, that study such cases, although this topic is widely discussed in the literature (e.g. in Roubini (2006) and Posen (2006)).