Recurrent Stochastic Fluctuations with Financial Speculation

Abstract

Throughout history, many countries have repeatedly experienced large swings in asset prices, which are usually accompanied by large fluctuations in macroeconomic activity. One of the characteristics of the period before major economic fluctuations is the emergence of new financial products; the situation prior to the 2008 financial crisis is a prominent example of this. During that period, a variety of structured bonds, including securitized products, appeared. Because of the high returns on such financial products, many economic agents were involved in them for speculative purposes, even if they were riskier, producing macro-scale effects. With this motivation, we present a simple macroeconomic model with financial speculation. Our model illustrates two points. First, stochastic fluctuations in asset prices and macroeconomic activity are driven by the repeated appearance and disappearance of risky financial assets, rather than expansions and contractions in credit availability. Second, in an economy with sufficient borrowing and lending, the appearance of risky financial assets leads to decreased productive capital, while in an economy with severely limited borrowing and lending, it leads to increased productive capital.