Should the Fed Increase the Interest Rate to Promote Financial Stability?

Benjamin Eden ()

No 16-00003, Vanderbilt University Department of Economics Working Papers from Vanderbilt University Department of Economics

Abstract: I study the question in the title in an economy that may have overvalued assets that can pop and lead to financial instability. Assets with no fundamentals are not easily detected and can be distinguished from assets with fundamentals only if someone buys information about the underlying project. When information is not private, there is a strictly positive probability that no one will buy it and the bubble-like asset will have value. When the government increases the interest rate, assets with no fundamentals have no value but welfare goes down. Thus an increase in the interest rate may promote financial stability but reduce welfare.

Keywords: Financial Stability; Bubbles; Monetary Policy; Informational Externalities (search for similar items in EconPapers)
JEL-codes: D0 E5 (search for similar items in EconPapers)
Date: 2016-01-26
New Economics Papers: this item is included in nep-mac and nep-mon
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