Theoretical Notes on Bubbles and the Current Crisis

• Authors: Jaume Ventura and Alberto Martin.
• BSE Working Paper: 110014 | September 15
• Keywords: Bubbles , credit constraints , dynamic inefficiency , pyramid schemes , financial accelerator , financial crisis
• JEL codes: E32, E44, G01, O40
• Bubbles
• credit constraints
• dynamic inefficiency
• pyramid schemes
• financial accelerator
• financial crisis

We explore a view of the crisis as a shock to investor sentiment that led to the collapse of a bubble or pyramid scheme in financial markets. We embed this view in a standard model of the financial accelerator and explore its empirical and policy implications. In particular, we show how the model can account for: (i) a gradual and protracted expansionary phase followed by a sudden andsharprecession; (ii) the connection (or lack of connection!) between financial and real economic activity and; (iii) a fast and strong transmission of shocks across countries. We also use the model to explore the role of fiscal policy.