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Working Paper, No. 2017-16, 2017
A Theoretical Model of Leaning Against the Wind (REVISED April 20, 2018)

Policymakers have long debated whether central banks should raise interest rates if they are concerned about a potential bubble, a policy known as leaning against the wind. In this paper, we develop a framework to study this question. We begin with the seminal work of Galí (2014) and argue that a small change in the model rules out his finding that raising rates amplifies bubbles rather than dampening then. More importantly, we argue that his setup does not provide any reason to intervene against bubbles. This leads us to consider an alternative model in which bubbles are credit-driven. In the simplest case, raising rates dampens bubbles but exacerbates the distortions bubbles introduce. But in this simple case, bubbles only cause harm when they arise, not when they burst. When we add default costs, so that bubbles also cause harm when they burst, raising rates increases welfare for sufficiently large default costs. Yet even when default costs are small, we find that a commitment to raise rates if a bubble persists can raise welfare ex-ante even though raising rates itself reduces welfare.



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