and severe consequences for the economy as long as monetary policy responds appropriately. whether an asset price bubble is occurring or not, as asset prices rise and boost the outlook for economic activity and inflation, monetary policy should respond by moving to a more restrictive stance. after a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. 8 as i pointed out in a paper that i presented at the federal reserve bank of kansas city's jackson hole conference in september, if monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. 9 more generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability. to be clear, i think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. this point of view implies that actions, such as attempting to " prick " an asset price bubble, should be avoided. i take this view for ( at least ) three important reasons. 10 first, asset price bubbles can be hard to identify. as a result, tightening monetary policy to restrain a bubble that has been misidentified can lead to weaker economic growth than is warranted. in addition, central bank actions to influence asset prices when the central bank is uncertain about the presence or extent of a bubble can interfere with the role of asset prices in allocating resources. 11 second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain. although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, raising interest rates may be very ineffective in restraining the bubble, because market participants expect such high rates of return from buying bubble - driven assets. 12 other research and historical examples ( which i will discuss later ) have suggested that raising interest rates may cause a bubble to burst more severely, thereby increasing the damage to the economy. 13 another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the the federal reserve's congressional mandate is actually couched in terms of three goals : maximum employment, stable prices, and

the risks to financial stability from asset price bubbles could be made a standard part of the regulatory system and would be operational at all times – whether a bubble was in progress or not. however, because specific or new types of market failures might be driving a particular asset price bubble, some future bubbles will almost certainly create unanticipated difficulties, and, as a result, adjustments to our policy stance to limit the market failure contributing to a bubble could be very beneficial if identified and implemented at the appropriate time. earlier, i pointed out that a bubble could be hard to identify. indeed, i think this is especially true of bubbles in the stock market. central banks or government officials are unlikely to have an informational advantage over market participants. if a central bank were able to identify bubbles in the stock market, wouldn't market participants be able to do so as well? if so, then a bubble would be unlikely to develop, because market participants would know that prices were getting out of line with fundamentals. however, although i believe that stock market bubbles might be hard to identify because they are typically not driven by credit booms ( which also makes them less harmful because their collapse is less likely to lead to financial instability ), when asset prices are rising rapidly at the same time that credit is booming, there may be a greater likelihood that asset prices are deviating from fundamentals, because laxer credit standards may be driving asset prices upward. 17 in this case, financial regulators at central banks and other institutions may have a greater likelihood of identifying that a bubble is in progress ; for example, they might have information that lenders have weakened their underwriting standards and that credit extension is rising at abnormally high rates. the reasoning here suggests that a rapid rise in asset prices accompanied by a credit boom provides a signal that should lead central bankers and other financial supervisors to carefully scrutinize financial developments to see if market failures might be driving the asset price boom. the resulting analysis of financial developments might then lead policymakers to consider implementing policies to address the imperfections behind the market failures and thereby help reduce the magnitude of the bubble. some historical examples i would like to now turn to a few examples from u. s. history and international experience that highlight the interaction between asset price bubbles, financial stability, and the policy framework. the stock market boom of the 1920s the roaring twenties and the onset of the great depression present a particularly drastic example. the u. s. economy thrived during the