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Prof. Jaume Ventura

CREI (Centre de Recerca en Economia Internacional) and Universitat Pompeu Fabra, Barcelona, Spain

Authors: Alberto Martin and Jaume Ventura

Abstract: This paper develops a model of the bubbly economy and uses it to study the effects of bailout policies. In the bubbly economy, weak enforcement institutions do not allow firms to pledge future revenues to their creditors. As a result, ‘fundamental’ collateral is scarce and this impairs the intermediation process that transforms savings into capital. To overcome this shortage of ‘fundamental’ collateral, the bubbly economy creates ‘bubbly’ collateral. This additional collateral supports an intricate array of intra- and inter-generational transfers that allow savings to be transformed into capital and bubbles. Swings in investor sentiment lead to fluctuations in the amount of bubbly collateral, giving rise to bubbly business cycles with very rich and complex dynamics. Bailout policies can affect these dynamics in a variety of ways. Expected bailouts provide additional collateral and expand investment and the capital stock. Realized bailouts reduce the supply of funds and contract investment and the capital stock. Thus, bailout policies tend to foster investment and growth in normal times, but to depress investment and growth during crisis periods. We show how to design bailout policies that maximize various policy objectives.

JEL classification: E32, E44, O40

Keywords: bubbles, cost of capital, economic growth, financial frictions, pyramid schemes

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