Heads I Win, Tails I Get Bailed Out: On Moral Hazard and Asset Price Bubbles

Abstract: Recent years’ asset price bubbles and financial crises have incurred a debate about central banks’ role in times of considerable movements in asset prices. Previous research has found that central banks should react to break-downs of asset price bubbles but not to build-ups. The consequence is an apparently asymmetric reaction function possibly leading to moral hazard behavior with investors, inducing them to take excessive risks since they do not have to bear the full down-side risks. The aim of this thesis is to examine how such behavior can be mitigated. A theoretical model is developed as a game between a central banker and an investor, where expectations about central bank behavior can give incentives for excessively risky investor behavior. It is found that uncertainty regarding the central banker’s preferences can mitigate excessive risk-taking and moral hazard behavior.