Central Bank Intervention, Bubbles and Risk in Walrasian Financial Markets

Abstract

The paper investigates the effects of central bank interventions in financial markets, composed of asymmetrically-informed rational investors and noise traders. If the central bank suspects a bubble, it should lift the real risk-free rate to deflate the bubble in “leaning against the wind”. A rise in the real risk-free rate reduces the risk of rational informed investors, and increases the risk of rational uninformed investors. If the central bank intervenes through the nominal risk-free rate and the Fisher arbitrage condition holds, an increase in the nominal rate is transferred to inflation, thereby dampening the policy effect. Conversely, this implies that the central bank can also deflate the bubble by inducing a reduction in inflationary expectations. The effect on the informed investor risk remains ambiguous, while the risk of he uninformed investor grows, but only if they suffer from money illusion.