This paper provides a guide to macroeconomic applications of the theory of rational bubbles.It shows that rational bubbles can be easily incorporated into standard macroeconomic models, and illustrates how they can be used to account for important macroeconomic phenomena. It also discusses the welfare implications of rational bubbles and the role of policy in managing them.Finally, it provides a detailed review of the literature.
JEL classi…cation: E32, E44, O40Keywords: bubbles, credit, business cycles, economic growth, …nancial frictions, pyramid schemes Martin: amartin@crei.cat. Ventura: jventura@crei.cat. All authors: CREI, Universitat Pompeu Fabra and Barcelona GSE, Ramon Trias Fargas 25-27, 08005-Barcelona, Spain. We thank Janko Heineken and Ilja Kantorovich for superb research assistance. Martin acknowledges support from the Spanish Ministry of Economy, Industry and Competitiveness (grant ECO2016-79823-P) and from the ERC (Consolidator Grant FP7-615651-MacroColl). Ventura acknowledges support from the Spanish Ministry of Economy and Competitiveness (grant ECO2014-54430-P) and from the ERC Horizon 2020 Research and Innovation Programme (grant agreement 693512). In addition, both authors acknowledge support from the Spanish Ministry of Economy and Competitiveness, through the Severo Ochoa Programme for Centres of Excellence in R&D (SEV-2015-0563), from the CERCA Programme/Generalitat de Catalunya, from the Generalitat de Catalunya (grant 2014SGR-830 AGAUR), and from the Barcelona GSE Research Network.Recent developments in …nancial markets have made it clear that macroeconomists need good models of asset prices ‡uctuations and their e¤ects on the real economy. This guide reviews one such class of models, which are based on two simple premises or working hypotheses. The …rst one is that asset prices are composed of a fundamental and a bubble. Many observed movements in asset prices are not due to changes in the fundamental, but instead they are due to changes in the bubble driven by random and capricious shifts in market psychology. The second hypothesis is that the existence of bubbles is not inconsistent with the assumption of individual rationality. In fact, shifts in market psychology can be easily incorporated into standard macroeconomic models that rely on rational expectations, individual maximization, and market clearing.These two hypotheses de…ne the research on the macroeconomics of rational bubbles. The key words are macroeconomic and rational. Macroeconomic in the sense that this research is not interested in explaining the causes and e¤ects of pricing anomalies or pathologies in some speci…c market, e.g. tulips, but rather in understanding large, widespread ‡uctuations in asset prices in modern economies. Rational in the sense that one of its key insights is that there are multiple market psychologies that are consistent with individual rationality. Whereas macroeconomists typically focus on one such psychology, i.e., asset prices are equal to the fundamental, there is no compelling reas...