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Did the FED React to Asset Price Bubbles?

  • Marc-Andre Luik and Dennis Wesselbaum
Published/Copyright: February 5, 2021

Abstract

This paper investigates whether the Federal Reserve Bank (FED) reacted to asset price bubbles before the Great Recession and whether this affected macroeconomic variables. We estimate a DSGE model featuring a financial accelerator and a process for asset price bubbles with different Taylor-rule specifications. We find that a Taylor-rule with a feedback to Tobin’s Q and bubble shocks fits best. Our findings suggest that the FED followed a cleaning rather than a leaning approach prior to the global financial crisis (GFC). Then, we perform a counterfactual analysis and show that this policy created a lower interest rate prior to the GFC compared to a standard Taylor-rule without feedback to financial variables.

JEL Classification: C11; E32; E44; E62

Corresponding author: Dennis Wesselbaum, University of Otago, Clyde Street 60, Dunedin 9054, New Zealand, E-mail:

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Received: 2020-05-27
Accepted: 2021-01-06
Published Online: 2021-02-05

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