Monetary Policy and Inflation Dynamics in Asset Price Bubbles

This paper integrates an asset price bubble and agency costs in firms' price-setting decisions into a monetary DSGE framework. Amplified by nominal wage rigidities, an asset price bubble causes an inefficiently excessive boom. Inflation, however, remains moderate in the boom, because a loosening in financial tightness lowers the agency costs and adds downward pressure on inflation. Stabilizing inflation makes the excessive boom even excessive in the short run. The optimal monetary policy calls for monetary tightening to restrain the boom at the cost of greater volatility in inflation.