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Rational bubbles and expectation-driven fluctuations

Authors


  • We thank an anonymous referee for suggestions which improved the paper. We would like to thank also Francesco Magris for his contribution to the development of some of the ideas presented in this paper, and participants in the 12th Public Economic Theory Conference, held in Bloomington in June 2011, and to the 11th SAET Conference, held in Faro in June 2011, for their comments.

Email: stefano.bosi@univ-evry.fr

Abstract

In this paper, we propose a unified approach to understand the fluctuations of a rational bubble. We focus on an overlapping generations exchange economy where each household makes a portfolio choice between money, held because of a liquidity constraint, and another asset with no fundamental value. We show the existence of equilibria where the second asset takes a positive value as a pure rational bubble. There may exist endogenous cycles and bubble fluctuations driven by the volatility of agents' expectations. An expansionary monetary policy can shelter the economy from these endogenous fluctuations, but this positive effect is counterbalanced by a welfare loss according to the Friedman critique: there is a trade-off between the stability and the stationary welfare target. Eventually, we consider a temporary bubble on real balances as an alternative source of self-fulfilling cycles.

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