Limited Liability, Asset Price Bubbles and the Credit Cycle: The Role of Monetary Policy

Jakub Matějů and Michal Kejak ()

Working Papers from Czech National Bank, Research and Statistics Department

Abstract: This paper suggests that the dynamics of the non-fundamental component of asset prices are one of the drivers of the credit cycle. The presented model builds on the financial accelerator literature by including a stock market where investors with limited liability trade stocks of productive firms with stochastic productivities. Investors borrow funds from the banking sector and can go bankrupt. Their limited liability induces a moral hazard problem which shifts demand for risk and drives prices of risky assets above their fundamental value. Embedding the contracting problem in a New Keynesian general equilibrium framework, the model shows that expansionary monetary policy induces loose credit conditions and leads to a rise in both the fundamental and non-fundamental components of stock prices. A positive shock to the non-fundamental component triggers a credit cycle: collateral value rises, and lending and default rates decrease. These effects reverse after several quarters, inducing a credit crunch. The credit boom lasts only while stock market growth maintains sufficient momentum. However, monetary policy does not reduce the volatility of inflation and the output gap by reacting to asset prices.

Keywords: Credit cycle; limited liability; monetary policy; non-fundamental asset pricing (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 G10 (search for similar items in EconPapers)
Date: 2015-12
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac and nep-mon
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https://www.cnb.cz/export/sites/cnb/en/economic-re ... wp/cnbwp_2015_16.pdf

Related works:
Working Paper: Limited Liability, Asset Price Bubbles and the Credit Cycle: The Role of Monetary Policy (2015)
Working Paper: Limited Liability, Asset Price Bubbles and the Credit Cycle. The Role of Monetary Policy (2015)
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