Deflating asset price bubbles with leverage constraints and monetary policy

• Published in: Journal of economic behavior & organization 2018-11, Vol.155, p.1-27
• Main Authors: Fenig, Guidon, Mileva, Mariya, Petersen, Luba
• Format: Article
• Language: English
• Subjects: Asset price bubbles; Experimental macroeconomics; General equilibrium; Heterogeneous expectations; Laboratory experiment; Leverage; Monetary policy; Production economy
• ISSN: 0167-2681; 1879-1751
• DOI: 10.1016/j.jebo.2018.06.021

•Within a laboratory macroeconomy, we study the effects of a set of central banks' policies onproduction and asset prices.•Leverage constraints are circumvented with higher labor supply and result in higher asset prices.•Raising interest rates in response to asset price inflation reduces asset price bubbles.•The ability to trade assets and earn speculative gains rises welfare by reducing investors' need to supply costly labor.•A model of heterogeneous expectations is developed to rationalize our experimental findings. We develop an experimental production economy to study the general equilibrium and welfare effects of speculation and stabilization policies. Participants playing the role of household-investors interact in labor, output, and, in some treatments, asset markets. Without the ability to trade assets, participants over-supply costly labor to acquire saving. The presence of asset markets improves welfare by allowing investors to substitute labor income for speculative gains. Asset prices deviate substantially from fundamental value. Leverage constraints that prevent investors from borrowing for speculation are ineffective at stabilizing asset prices. Households often circumvent the constraints by excessively supplying labor and generating increased wealth which can be used for speculation. Wealth inequality is worsened due to endogenously higher interest accumulated by borrowers and savers. An asset inflation targeting policy fuels initial asset price growth but, as interest rates rise rapidly, effectively deflates asset price deviations. With learning, the policy stabilizes asset prices and consequently interest rates, which enhances welfare and reduces inequality. We develop a model of heterogeneous expectations to rationalize our experimental findings.