DP8038 Theoretical Notes on Bubbles and the Current Crisis

Author(s): Alberto Martín, Jaume Ventura
Publication Date: October 2010
Keyword(s): bubbles, credit constraints, dynamic inefficiency, financial accelerator, financial crisis, pyramid schemes
JEL(s): E32, E44, G01, O40
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8038

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 and sharp recession; (ii) the connection (or lack of connection!) between financial and real economic activity and; (iii) a fast and strong transmission of shocks across sectors and countries. We also use the model to explore the role of fiscal policy.