analysis. Therefore, we focus our comparison on Figures 2 and 3.
A non-fundamental shock causes an increase in asset prices, which induces
a jump in gross investment and output. As long as the bubble inflates, asset
prices, investment and output continue to grow. This overinvestment implies
a reduction of the resources available for consumption as found in (Blanchard
2000). When the bubble bursts, investment and asset prices collapse and so
does output. However, there are important differences in the magnitude and
volatility patterns for the optimal policy (Figure 2 and for the Taylor rule
(Figure 3).
The optimal policy motivates a more aggressive monetary policy reaction
than the Taylor rule when the economy is hit by a persistent non-fundamental
shock — see the lower-left panel. The stronger reaction of the optimal policy
guarantees that asset prices stay closer to its equilibrium value under the
optimal policy than under the Taylor rule. That behaviour of asset prices
implies that investment and output, under the optimal policy, do not deviate
as much from their equilibrium values as they do for the Taylor rule. Actually,
from the observation of the output impulse-response function (see the lower-right
panel of Figure 2) the optimal policy seems to be more effective in smoothing
the output path to the steady-state, resulting in a soft landing of the economy
after a crash in asset prices. The optimal policy achieves a soft landing by
stimulating consumption.
Turning now to the t-steps ahead standard deviations of output and real
interest rate, the results reflect the uncertainty of the agents concerning the
future evolution of output and the real interest rate, given that a persistent
non-fundamental shock has hit the economy. Table 4 portrays the difference
between the hard landing brought about by a Taylor rule and the soft landing
under the optimal policy. While the hard landing makes output volatile in
the near future, the soft landing increases dispersion in the not so near future.
12