Scandinavian Working Papers in Economics

SSE Working Paper Series in Economics,
Stockholm School of Economics

No 2015:1: Rational Bubbles and Economic Crises: A Quantitative Analysis

David Domeij () and Tore Ellingsen ()
Additional contact information
David Domeij: Dept. of Economics, Postal: Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden
Tore Ellingsen: Dept. of Economics, Postal: Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden

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

JEL-codes: E31; E32; E41; E63

49 pages, February 13, 2015

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