Question

Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a market bubble? Explain using the Gordon growth model.

Short answer

If investors in the stock market anticipate that dividends will expand rapidly, a bubble is likely to form. Another factor contributing to the bubble might be a lower rate of return on equity investments.

Step-by-step solution

Gordon growth model :

$P_0=\frac{D_0(1+g)}{(k_e-g)}$

where,

$D_0$= most recent dividend paid,

$g$= expected constant growth rate in dividends,

$K_e$= requested return on an investment in equity.

Explanation :

If investors in the stock market anticipate that dividends will expand rapidly, a bubble is likely to form. Another factor contributing to the bubble might be a lower rate of return on equity investments. As a result, the denominator of the Gordon growth model would be lowered, resulting in an increase in stock prices.

Use of Monetary policy :

It may be employed in two ways to deflate stock market bubbles before they cause harm.

a) The Fed can cut interest rates by increasing the money supply, lowering bond returns. Because bonds are a different asset than stocks, investors are more willing to tolerate a lower necessary rate of return on an equity investment. In the Gordon growth model, this lowers $k_e$and raises $\left(P_0\right)$, implying an increase in stock values.

b) Finally, a reduction in interest rates is expected to boost the economy by raising consumer expenditure. As a result, $g$in the Gordon growth model rises, causing stock values to climb as well. $\left(P_0\right)$