Bubbly Recessions

Abstract

We develop a tractable bubbles model with financial frictions and downward wage rigidity. Competitive speculation in risky bubbles can result in excessive investment booms that precede inefficient busts, where post-bubble aggregate economic activities collapse below the pre-bubble trend. Risky bubbles can reduce ex-ante social welfare, and leaning-against-the-bubble policies that balance the boom-bust trade-off can be warranted. We further show that the collapse of a bubble can push the economy into a "secular stagnation" equilibrium, where the zero lower bound and the nominal wage rigidity constraint bind, leading to a persistent recession, such as the Japanese "lost decades."

Credit booms, debt overhang and secular stagnation

“…In addition, some recent contributions analyze the effects of (the burst of) asset price bubbles on economic growth (cf. Boullot, 2017;Hanson and Phan, 2017;Biswas et al, 2017).…”

“…Finally, Schmitt-Grohé and Uribe (2016, 2017) introduce an exogenous lower bound on the growth rate of the nominal wage that becomes binding in case of unemployment. The same mechanism is used by Hanson and Phan (2017) and Biswas et al (2017).…”

Bridging between policymakers’ and economists’ views on bubbles

“…Once we move to more elaborate models of bubbles that are based on dynamic inefficiency or borrowing constraints, there may be a cost to waiting to act against a bubble, especially if the bubble can burst stochastically. One nice illustration of this is the paper by Biswas, Hanson, and Phan (2018). They consider a model in which bubbles arise because of borrowing constraints.…”

“…A second scenario in which theoretical models of bubbles could ultimately be adopted by policymakers is if economists build on the models that policymakers currently dismiss to make these models seem more relevant and applicable to the scenarios policymakers face. One example of this is the Biswas, Hanson, and Phan (2018) paper I discussed earlier, which introduces rigid wages into a model of bubbles driven by binding borrowing constraints. This modification allows for the possibility that letting a bubble grow can both serve a useful role and magnify the distortions that arise when the bubble bursts.…”

Wealth Preference and Rational Bubbles

“…The only substantive restriction that we impose is that the household's utility function is additively separable between consumption and wealth. 10 Our paper is organized as follows. In Section 2, we brie ‡y motivate the preference for 9 There has recently been a rising interest in macroeconomics for the monetary policy consequences of bubbles (Gali 2014 wealth.…”