Leave the bubble alone!: Deflating asset price bubbles in an experimental macroeconomy

This paper examines the effects of monetary policy on asset price bubbles and production in a laboratory experimental economy. Participants play the role of household investors who are faced with consumption, labor, and investment decisions. In a between-subject design, we compare how participants' decisions and aggregate dynamics respond to the presence of an asset market and to policies that are intended to stabilize asset prices. We find that introducing asset markets to the economy does not generate significant real effects despite large deviations of asset prices from fundamental value. Both leverage constraints and monetary policy responses to asset price inflation inadvertently generate larger deviations of asset prices from fundamental value. The prospect of a binding leverage constraint results in increased labor supply and, consequently, larger cash balances that fuel larger and more persistent asset price deviations. A ``leaning against the wind'' interest rate policy generates low nominal interest rates in the early periods of participants' lifecycles due to its relatively weaker response to output price inflation. Low interest rates incentivize subjects to speculate and thereby generate a quick acceleration in asset prices. As interest rates rise quickly and significantly in response to asset price inflation, monetary policy becomes more salient and effective at stabilizing asset demand.