Bubble Flashcards
When are bubbles purchased?
Purchased by the young generation, as a savings vehicle. Individual can either invest in bubbles or capital. Return of bubbles must follow the return of savings.
Consumption only occurs when old.
Are investors risk averse or risk neutral
Investors in bubbles are risk neutral - they don’t care the bubble may burst.
Rationality restrictions on bubbles
- expected return of a bubble in T+ 1 must equal the return on capital in T+1
- the price of the bubble must be lower than the individuals wage
Trade off for the bubble
Individual either invests in the bubble or in capital accumulation
Consequence of trading bubbles intergenerationally
Reduces the young generation’s capacity to invest. Money is transferred to the older generation
What is xt?
And what does Et Xt+1 describe?
We define xt since we want to move from two state variables to one state variable
Et Xt+1 describes the bubble dynamics during a bubbly episode
Recall it comes from transforming the non arbitrage condition. We use the xt identity and the equation of motion for capital accumulation (difference between wage and bt)
Why is return for a bubble uncertain
It could burst
Dynamically inefficient
Capital incomes fall short of necessary investments to sustain k*
Difference between bubbles and capital
Bubbles are cost less to create but have no use in production.
Capital is costly to produce but useful in production.
Problems with the basic framework / basic OLG model with bubbles
Bubbles crowd out investment in K, which contradicts empirical evidence
k,y,c shrink
Model also predicts bubbles only occur when model is dynamically inefficient
Restriction on alpha to be feasible
Must be < 0.5. Easy to see graphically, must have an intercept with the steady state line in order to have a bubbly episode in equilibrium. Otherwise feasibility constraint is violated
This implies an economy is dynamically inefficient…
Introduction of financial frictions
Agents differ with respect to their efficiency to build up physical capital. They differ with their MPK
No frictions = productive agents invest on behalf of unproductive
Wage for p and u agents
The same
Benefit of a growing bubble with financial frictions
Average investment efficiency increases. Investment efficiency is increasing until p agents are also investing in bubbles. Reduced capacity of U agents to invest, increased capacity of P agents. P agents essentially investing on behalf of U agents
A growing bubble increases capital accumulation and output
Effect of a bubble on capital accumulation when there are financial frictions
Positive and negative effect on capital accumulation, negative since crowds out investment, positive since initially only unproductive invest in bubble meaning only those investing in capital are productive agents.
Old bubbles crowd out investment.
New bubbles created by P agents crowds in investment
