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Leverage and Bubbles: Experimental Evidence

Paul Gortner and Baptiste Massenot

No 239, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

Abstract: We investigate the effect of leverage on bubbles in an asset market experiment. We expect higher leverage to produce larger bubbles because (i) it creates moral hazard in a setup with limited liability and (ii) it increases aggregate liquidity. Inconsistent with the moral hazard channel, which we test by holding aggregate liquidity constant, higher leverage does not produce larger bubbles. To understand this unexpected result, we run the same experiment with a different framing: instead of repaying debt, participants can earn a bonus. This bonus treatment produces larger bubbles, suggesting that more leveraged participants trade more cautiously to avoid default. Finally, bubbles are larger and increase over time when we keep leverage constant over time by injecting liquidity in the economy. Overall, these results suggest that higher leverage inflates bubbles not because of moral hazard but because of more abundant liquidity.

JEL-codes: E58 G28 (search for similar items in EconPapers)
Date: 2020, Revised 2020
New Economics Papers: this item is included in nep-ban, nep-cba, nep-exp and nep-mac
References: Add references at CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:239

DOI: 10.2139/ssrn.3311378

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