Undesired monetary policy effects in a bubbly economy

Monetary policy can be responsible for asset price bubble episodes under specific monetary- financial conditions. We evaluate the effects of monetary policy shocks on asset price bubbles by estimating a Markov-switching Bayesian Vector Autoregression on US 1960-2019 data, where states for the interaction of asset prices and monetary outcomes affect the realization of bubbles. We rationalize the evidence with a Markov-switching Overlapping Generations model, generating a bubbly and a no-bubbly economy with a regime-specific monetary policy. By matching the empirical impulse responses, we find that the monetary-financial states of the economy can generate amplified instability under high equity premia and asset price bubble. In a bubbly economy, a monetary tightening is ineffective in reducing stock prices, increasing real rates and inflating bubbles. Expectations to switch to a no bubbly scenario produce stabilizing effects.