Optimal Macroprudential Policy and Asset Price Bubbles, WP/21/184, August 2019

We study the interplay between firms’ indebtedness and stock market bubbles. A bubble relaxes borrowing constraints and increases borrowing capacity of credit-constrained firms. Yet a deflating bubble amplifies downturns when constraints start binding. We show analytically and quantitatively that optimal macroprudential policy should respond to bubbles in a non-monotonic way, which depends on the underlying level of indebtedness. If the level of debt is moderate, policy should accommodate the bubble to reduce the incidence of a binding borrowing constraint. If debt is elevated, policy should lean against the bubble more aggressively to mitigate the externalities when constraints bind. JEL Classification: E2, E44, G1