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Rational Bubbles and Economic Crises: A Quantitative Analysis

David Domeij () and Tore Ellingsen ()

No 2015:1, SSE Working Paper Series in Economics from Stockholm School of Economics

Abstract: We extend the Bewley-Aiyagari-Huggett model by incorporating an incomplete stock market and a persistent income process. In this quantitative general equilibrium framework, non-fundamental asset values are both large and desirable for realistic parameter values. However, if expectations shift from one equilibrium to another, some markets may crash as others soar. In the presence of nominal assets and contracts, such movements can be highly detrimental. Our analysis is consistent with the view that some of the world’s large recessions were caused by an avoidable failure of monetary and fiscal policy to prevent deflation in the aftermath of bursting asset price bubbles.

Keywords: Bubbles; Incomplete Markets; Depressions; Fiscal Policy; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E31 E32 E41 E63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge and nep-mac
Date: 2015-02-13
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Handle: RePEc:hhs:hastec:2015_001