CHAPTER 18 The Conduct of Monetary Policy: Strategy and Tactics 483 The resulting losses on subprime loans and securities eroded the balance sheets of financial institutions, causing a decline in credit (deleveraging) and a sharp fall in business and household spending, and therefore in economic activity As we saw during the subprime financial crisis, the interaction between housing prices and the health of financial institutions following the collapse of the housing price bubble endangered the operation of the financial system as a whole and had dire consequences for the economy Bubbles that are driven solely by overly optimistic expectations, but which are not associated with a credit boom, pose much less risk to the financial system For example, the bubble in technology stocks in the late 1990s (described in Chapter 7) was not fuelled by credit, and the bursting of the tech-stock bubble was not followed by a marked deterioration in financial institution balance sheets The bursting of the tech-stock bubble thus did not have a very severe impact on the economy and the recession that followed was quite mild Bubbles driven solely by irrational exuberance are therefore far less dangerous than those driven by credit booms BUBBLES DRIVEN SOLELY BY IRRATIONAL EXUBERANCE Should Central Banks Respond to Bubbles? One view is that central banks should not respond to bubbles It is argued that bubbles are nearly impossible to identify If central banks or government officials knew that a bubble was in progress, why wouldn t market participants know as well? If so, then a bubble would be unlikely to develop, because market participants would know that prices were getting out of line with fundamentals This argument applies very strongly to asset-price bubbles that are driven by irrational exuberance, as is often the case for bubbles in the stock market Unless central bank or government officials are smarter than market participants, which is unlikely given the especially high wages that savvy market participants garner, they will be unlikely to identify when bubbles of this type are occurring There is then a strong argument for not responding to these kinds of bubbles On the other hand, when asset-price bubbles are rising rapidly at the same time that credit is booming, there is a greater likelihood that asset prices are deviating from fundamentals, because laxer credit standards are driving asset prices upward In this case, central bank or government officials have a greater likelihood of identifying that a bubble is in progress; this was indeed the case during the housing market bubble in the United States because these officials did have information that lenders had weakened lending standards and that credit extension in the mortgage markets was rising at abnormally high rates Should Monetary Policy Try to Prick AssetPrice Bubbles? Not only are credit-driven bubbles possible to identify, but as we saw above, they are the ones that are capable of doing serious damage to the economy There is thus a strong case for central banks to respond to possible credit-driven bubbles But what is the appropriate response? Should monetary policy be used to try to prick a possible asset-price bubble that is associated with a credit boom by raising interest rates above what is desirable for keeping the economy on an even keel? Or are there other measures that are more suited to deal with credit-driven bubbles? There are three strong arguments against using monetary policy to prick bubbles by raising interest rates more than is necessary for achieving price stability and minimizing economic fluctuations First, even if an asset-price bubble is of the credit-driven variety and so can be identified, the effect of raising interest rates on asset prices is highly uncertain Although some economic analysis suggests that