How Monetary Policy Should Respond To The Rational Asset Price Bubble

China has entered a new stage of economic development, facing a downward pressure on the economy. The macroeconomic need to run in a reasonable rang in case of the potential systemic financial crisis. Past experience and research, especially the global financial crisis suffered by some countries over the past decade, revealed that the macroeconomic has a close relationship with the asset price, the spectacular rise and subsequent collapse of the asset price will bring huge risks to the economy. In 2015, China’s stock market experienced a giant fluctuation, which rise and decline rapidly, while the real estate asset prices also experienced a rapid rise in a short time. There are indications that the current domestic capital market exists price bubble which can not be ignored. If asset price bubble expansion can not be controlled, it will impact China’s macroeconomic performance and the steady of economic development. In this context, the role that monetary policy should play is a heated debate, which needs to be studied by standardize economic methods.Whether the monetary policy should react to the asset price bubble, the academic community has two types of diametrically opposed views. In the pre-crisis years, the traditional view among most policy makers was that central banks should focus on controlling inflation and stabilizing the output gap, and thus ignore the asset price developments. Unless the latter are seen as a threat to price or output stability. But that view has been challenged after the crisis in 2007-2009.Because many authors and policy makers finding that the achievement of low and stable inflation is not a guarantee of financial stability and then calling for central banks to pay special attention to developments in asset markets. So whether China’s current monetary policy has internal consistency with "leaning against the wind". This paper develops an overlapping generations model with nominal rigidities and analyzes its equilibrium, and then describes the impact on the equilibrium of monetary policy rules that respond systemically to the size of the bubble. The paper’s main results are as follows, the asset price can be decomposed into two components and the monetary policy has different impact on those tow components. Contrary to the conventional wisdom, a stronger interest rate response to bubble fluctuations ("leaning against the wind policy") may raise the volatility of asset prices and of their bubble component. The optimal policy must strike a balance between stabilization of current aggregate demand-which calls for a positive interest rate response to the bubble-and stabilization of the bubble itself-which would warrant a negative interest rate response to the bubble. The policy-makers should use "leaning against the wind" monetary policy prudently based on the health of the capital markets.