Bubble Cycle

Abstract

This paper analyzes the boom–bust cycle driven by rational bubbles in an overlapping generations economy that is subject to borrowing constraints. At the heart of the analysis is the interplay among savings, investment, and the interest rate. Bubbles are more likely to crowd investment in, the stronger is the intertemporal substitution in consumption, and the more severe is the borrowing constraint. This model contradicts with Abel et al (1989)’s condition in both dimensions of dynamic efficiency and the occurrence of bubbles. We characterize the global dynamics of a stochastically bubbly economy, where emergent bubbles are followed by the investment boom, but the bursting of bubbles results in the recession. The recession is serious relative to the boom, with biased holding of bubbles.