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Bubbly Recessions

Toan Phan (), Andrew Hanson and Siddhartha Biswas
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Andrew Hanson: University of North Carolina Chapel Hill
Siddhartha Biswas: University of North Carolina, Chapel Hill

No 440, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: We analyze the welfare tradeoff of rational bubbles in a tractable growth model with financial frictions and downward nominal wage rigidity. The monetary authority follows an inflation targeting Taylor-type interest rate rule that is constrained by the zero lower bound. We show that competitive speculation in a risky bubbly asset can result in an excessive investment boom that precedes an inefficient bust, and a larger boom precedes a deeper bust. In particular, the collapse of a large 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 with inefficiently low employment, investment and output. The inefficiency is due to the pecuniary externality of speculative investment that arises from combination of financial frictions and nominal rigidities. The model provides a framework to evaluate macroprudential leaning-against-the-bubble policies to balance the welfare tradeoff between the boom and bust phases of bubbly episodes.

Date: 2018
New Economics Papers: this item is included in nep-cba, nep-dge, nep-fdg and nep-mac
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