Bubbles and Stagnation

Abstract This paper studies the consequences of asset bubbles for economies that are vulnerable to persistent stagnation. Stagnation is the result of a shortage of assets that creates an oversupply of savings and puts downward pressure on the level of interest rates. Once the zero lower bound on the nominal interest rate binds, the real rate cannot adjust further downward, forcing output to fall instead. In such context, bubbles are useful as they expand the supply of assets, absorb excess savings, and raise the natural interest rate—the real rate that is compatible with full employment—crowding in consumption and raising welfare. However, a risky bubble that can collapse with positive probability is smaller and less effective in doing so than a safe bubble. In this case, fiscal policy in the form of promised bailout transfers in case of a bubble collapse, can support an existing bubble and improve its size.