Business Cycles with Asset Price Bubbles and the Role of Monetary Policy

This paper presents a dynamic general equilibrium model that incorporates profit-maximizing banks and inside money into a decentralized Ramsey economy. It offers an alternative to the monetary equilibrium model of Sidrauski with money in the utility function and that of Stockman with a cash-in-advance constraint, both of which are based on a centralized Ramsey model with outside money. The model shows how an expansionary monetary policy triggers the business cycle with an asset price bubble. The magnitude of the business cycle and the asset price bubble depend not only on the size but also on the anticipated duration of the monetary policy. Moreover, if the end of the expansionary monetary policy is followed by a banking crisis, the economy could experience a prolonged period of economic slowdown. Thus, the model is capable of analyzing the phenomenon of disequilibrium dynamics