Financial stability and interest rate adjustment in asset price boom-bust cycles

Whether monetary policy should directly respond to asset boom-bust cycles has been in debate for decades. This paper tries to answer the question from the collateral channel of assets on real economy. By adding a partially endogenous financial shock in a reduced-form New Keynesian model, we find optimal monetary policy exists in the trade-off between current economic growth and future financial instability led by credit crunch. The optimal monetary policy is non-linear in all parameters and largest adjustment exists at a moderate level of market optimism. Numerical simulations show it is more sensitive to firms' external financial dependence and how deep asset price would reverse in the future. If market irrational exuberance comes up, more monetary tightening is required when either probability or depth of reversal is underestimated.