DP11149 Secular Stagnation, Rational Bubbles and Fiscal Policy

Author(s): Coen N Teulings
Publication Date: March 2016
Keyword(s): bubbles, dynamic efficiency, Fiscal policy, macro, secular stagnation
JEL(s): E44, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11149

It is well known that rational bubbles can be sustained in a dynamically ineffcient economy, where the return to capital r is below the growth rate g. However, empirical evidence suggests that modern economies are most of the time on an efficient path with r > g. This paper shows that rational bubbles can be sustained when r < g for some episodes only. Bubbly assets are shown to enhance efficiency, although they do not allow the implementation of first-best. Where r < g was considered aprerequisite for the existence of bubbles, we show that bubbles cause r > g "on average". Fiscal policy can enhance both welfare and financial stability. Contrary to common wisdom, trade in bubbly assets implements inter generational transfers, while fiscal policy is needed for theimplementation of intragenerational transfers. Finally, we show that in an economy with risk aversion, bubbles may emerge even when there exists an asset with a risk-free return growing at rate g.