Capital Bubbles, Interest Rates, and Investment in a Small Open Economy

Abstract

We model a bubble in a productive asset (capital) on an explosive path, which diverges from the fundamental equilibrium and bursts with a positive probability. When the bubble grows, the small open economy borrows from the the world economy to finance investment and production, and banks charge the risk of the bubble bursting as an interest rate spread to debtors. Consequently, the interest rate spread widens as loans are increasingly backed by the bubble. When the bubble bursts, defaults cause a sudden stop of credit inflow from the world economy, investment falls, and the interest rate spread vanishes.

Regressive Welfare Effects of Housing Bubbles

“…A common theme in this literature is that rational bubbles emerge to reduce some inefficiency in the financial market, such as an aggregate shortage of assets for storage or a credit market imperfection, as in Martin and Ventura (2012), Hirano and Yanagawa (2017), Miao and Wang (2018), and Ikeda and Phan (2019). By departing from the pure bubble assumption and modeling a bubble as attached to a fundamentally useful durable asset such as housing, our paper is related to Arce and López-Salido (2011), Miao and Wang (2012), Wang and Wen (2012), Hillebrand and Kikuchi (2015), Zhao (2015), Thepmongkol (2019), andBasco (2016).…”