Rational bubbles and macroeconomic crisis
It is frequently suggested that bursting asset price bubbles precipitated the two major worldwide recessions during the last century as well as many other economic crises. This project intends to answer two main questions. First, what are the merits of this hypothesis? Second, what (if any) are the appropriate policy responses?
For the economics profession, this is an awkward hypothesis. Asset price bubbles play no role in the quantitative models that underpin policy-making in finance ministries and central banks. Instead, in responding to the recent global recession, we have relied on models in which the recession is caused by large shocks to preferences or technology. Our first goal is therefore to develop a medium-sized quantitative macroeconomic model with a central role for rational asset price bubbles. Using this model we can then (i) investigate the macroeconomic consequences of bursting asset bubbles and (ii) investigate the consequences of various policy responses (e.g., temporary interest rate changes, quantitative easing, and fiscal and debt policy) that monetary and fiscal authorities could enact if bubbles burst.
For the economics profession, this is an awkward hypothesis. Asset price bubbles play no role in the quantitative models that underpin policy-making in finance ministries and central banks. Instead, in responding to the recent global recession, we have relied on models in which the recession is caused by large shocks to preferences or technology. Our first goal is therefore to develop a medium-sized quantitative macroeconomic model with a central role for rational asset price bubbles. Using this model we can then (i) investigate the macroeconomic consequences of bursting asset bubbles and (ii) investigate the consequences of various policy responses (e.g., temporary interest rate changes, quantitative easing, and fiscal and debt policy) that monetary and fiscal authorities could enact if bubbles burst.
Final report
Purpose
This project intends to answer two main questions. First, to what extent macroeconomic crises in the last century have been caused by bursting asset price bubbles? If bursting asset prices bubbles cause crises, what are the appropriate policy responses? For the economics profession, this is an awkward hypothesis. Asset price bubbles play no role in the quantitative models that underpin policy-making in finance ministries and central banks. Our first goal is therefore to develop a medium-sized quantitative macroeconomic model with a central role for rational asset price bubbles. Using this model we can then (i) investigate the macroeconomic consequences of bursting asset bubbles and (ii) investigate the consequences of various policy responses that monetary and fiscal authorities could enact if bubbles burst.
Implementation
The project has so far generated four articles. All are co-authored with Tore Ellingsen. One article is published in Journal of Monetary Economics, one is accepted for publication in Econometrica, one is submitted to a leading international journal, and one is about to be submitted. We have also written an article for a broader non-academic audience, published in Ekonomisk debatt.
We have presented our work at several academic conferences and seminars.
Main results
In the article “Rational Bubbles and Public Debt Policy: A Quantitative Analysis” we implement the first goal. We develop a theoretical model to investigate if asset price bubbles are quantitatively important. We show that the model, when calibrated to the US economy, is consistent with large asset price bubbles. Furthermore, the model can generate risk-free real interest rates that are as low at those observed in the data, a feature that standard models have trouble capturing. With such low real interest rates (below the economy’s real growth rate), the government can keep the government debt to GDP ratio constant at no cost. Instead, the revenue (the seignorage) from the debt can be used for redistribution to reduce income inequality. Bubbles on private assets on the other hand increase inequality. From a welfare perspective it is therefore desirable to replace bubbles on private assets with government debt, keeping the real interest rate constant. In the article we show how quantitatively small taxes on private assets prone to bubbles can be welfare enhancing.
In the article “Rational Bubbles in UK Housing Markets” we show that an empirical test used to investigate the existence of asset price bubbles in UK housing markets is based on incorrect presumptions of the how market works and of legal rights.
In the article “Money Demand Recessions” we focus on the second goal. We extend the model to investigate the macroeconomic consequences of bursting asset price bubbles and investigate the appropriate design of economic policy. In the model, a crisis occurs when investors abandon a private asset bubble and instead invest in government debt. This increases the real value of money, i.e., it leads to deflationary pressure. If nominal prices and wages are slow to adjust, instead of deflation, the economy experiences excess supply of goods and labor. In the article we show that our model emulates the development in the US following the financial crisis in 2008-09. We also show that the recessions are easily avoidable, either by permanently increasing the public debt to GDP ratio or by permanently reducing the real interest rate (the implied reduction is quantitatively small when considering a price fall on private assets of the size observed during the financial crisis 2008-09).
In the article “Monetary Policy in Incomplete Markets” we develop a somewhat simpler version of the model. Here, we focus on the theoretical mechanisms instead of the quantitative implications.
We have also written an article in Swedish intended for a broader non-academic audience “Hur kan vi kurera ekonomiska kriser?” (Ekonomisk Debatt 4/2017) which primarily builds on the insights from the article “Money Demand Recessions”.
New research questions
Our framework is well suited to address questions in finance. Specifically, the model we developed can offer alternative explanations to so called anomalies in finance, e.g., the twin-share puzzle. This anomaly refers to the fact that two shares that are claims to identical dividend flows can trade at different prices. Such anomalies are usually explained by referring to irrational behavior. According to our model, there can exist bubbles of different sizes on otherwise identical assets making the prices consistent with rational behavior.
Our framework is also well suited to study recent changes in inequality. It is well documented that the observed increase in inequality is primarily driven by much higher than average income growth at the very top of the income distribution. It is also well documented that entrepreneurs are over-represented at the very top of the income distribution. In our model, entrepreneurship is the main building block when inequality is endogenously generated. We therefore believe that our framework is well suited to address the recent increase in inequality.
Dissemination of research
All our articles have been presented at research seminars at universities and central banks (University of Cologne, Helsinki Center of Economic Research, Federal Reserve Bank of Minneapolis, University of Bath, University of Wurzburg, University of Regensburg, Uppsala Universitet, IIES vid Stockholms Universitet, Handelshögskolan i Stockholm, SHOF, Greater Stockholm Macro Group, Norges Bank, Norges Handelshøyskole, Hanken, Handelshøyskole BI, Institutet för Näringslivsforskning).
We have also presented our work at international conferences (Barcelona GSE Summer Forum 2016, 2nd Conference on Financial Markets and Macroeconomic Performance vid Goethe University 2017, CREI's Workshop on Bubbles in Macroeconomics: Recent Developments, 2017)
Two of the articles are published in leading journals, one is submitted and one is about to be submitted to leading academic journals. They are all available on our web pages.
To spread our results outside the scientific community we have also written an article published in Ekonomisk Debatt, and presented our work in policy seminars at Nationalekonomiska Föreningen, and Finanspolitiska rådet.
This project intends to answer two main questions. First, to what extent macroeconomic crises in the last century have been caused by bursting asset price bubbles? If bursting asset prices bubbles cause crises, what are the appropriate policy responses? For the economics profession, this is an awkward hypothesis. Asset price bubbles play no role in the quantitative models that underpin policy-making in finance ministries and central banks. Our first goal is therefore to develop a medium-sized quantitative macroeconomic model with a central role for rational asset price bubbles. Using this model we can then (i) investigate the macroeconomic consequences of bursting asset bubbles and (ii) investigate the consequences of various policy responses that monetary and fiscal authorities could enact if bubbles burst.
Implementation
The project has so far generated four articles. All are co-authored with Tore Ellingsen. One article is published in Journal of Monetary Economics, one is accepted for publication in Econometrica, one is submitted to a leading international journal, and one is about to be submitted. We have also written an article for a broader non-academic audience, published in Ekonomisk debatt.
We have presented our work at several academic conferences and seminars.
Main results
In the article “Rational Bubbles and Public Debt Policy: A Quantitative Analysis” we implement the first goal. We develop a theoretical model to investigate if asset price bubbles are quantitatively important. We show that the model, when calibrated to the US economy, is consistent with large asset price bubbles. Furthermore, the model can generate risk-free real interest rates that are as low at those observed in the data, a feature that standard models have trouble capturing. With such low real interest rates (below the economy’s real growth rate), the government can keep the government debt to GDP ratio constant at no cost. Instead, the revenue (the seignorage) from the debt can be used for redistribution to reduce income inequality. Bubbles on private assets on the other hand increase inequality. From a welfare perspective it is therefore desirable to replace bubbles on private assets with government debt, keeping the real interest rate constant. In the article we show how quantitatively small taxes on private assets prone to bubbles can be welfare enhancing.
In the article “Rational Bubbles in UK Housing Markets” we show that an empirical test used to investigate the existence of asset price bubbles in UK housing markets is based on incorrect presumptions of the how market works and of legal rights.
In the article “Money Demand Recessions” we focus on the second goal. We extend the model to investigate the macroeconomic consequences of bursting asset price bubbles and investigate the appropriate design of economic policy. In the model, a crisis occurs when investors abandon a private asset bubble and instead invest in government debt. This increases the real value of money, i.e., it leads to deflationary pressure. If nominal prices and wages are slow to adjust, instead of deflation, the economy experiences excess supply of goods and labor. In the article we show that our model emulates the development in the US following the financial crisis in 2008-09. We also show that the recessions are easily avoidable, either by permanently increasing the public debt to GDP ratio or by permanently reducing the real interest rate (the implied reduction is quantitatively small when considering a price fall on private assets of the size observed during the financial crisis 2008-09).
In the article “Monetary Policy in Incomplete Markets” we develop a somewhat simpler version of the model. Here, we focus on the theoretical mechanisms instead of the quantitative implications.
We have also written an article in Swedish intended for a broader non-academic audience “Hur kan vi kurera ekonomiska kriser?” (Ekonomisk Debatt 4/2017) which primarily builds on the insights from the article “Money Demand Recessions”.
New research questions
Our framework is well suited to address questions in finance. Specifically, the model we developed can offer alternative explanations to so called anomalies in finance, e.g., the twin-share puzzle. This anomaly refers to the fact that two shares that are claims to identical dividend flows can trade at different prices. Such anomalies are usually explained by referring to irrational behavior. According to our model, there can exist bubbles of different sizes on otherwise identical assets making the prices consistent with rational behavior.
Our framework is also well suited to study recent changes in inequality. It is well documented that the observed increase in inequality is primarily driven by much higher than average income growth at the very top of the income distribution. It is also well documented that entrepreneurs are over-represented at the very top of the income distribution. In our model, entrepreneurship is the main building block when inequality is endogenously generated. We therefore believe that our framework is well suited to address the recent increase in inequality.
Dissemination of research
All our articles have been presented at research seminars at universities and central banks (University of Cologne, Helsinki Center of Economic Research, Federal Reserve Bank of Minneapolis, University of Bath, University of Wurzburg, University of Regensburg, Uppsala Universitet, IIES vid Stockholms Universitet, Handelshögskolan i Stockholm, SHOF, Greater Stockholm Macro Group, Norges Bank, Norges Handelshøyskole, Hanken, Handelshøyskole BI, Institutet för Näringslivsforskning).
We have also presented our work at international conferences (Barcelona GSE Summer Forum 2016, 2nd Conference on Financial Markets and Macroeconomic Performance vid Goethe University 2017, CREI's Workshop on Bubbles in Macroeconomics: Recent Developments, 2017)
Two of the articles are published in leading journals, one is submitted and one is about to be submitted to leading academic journals. They are all available on our web pages.
To spread our results outside the scientific community we have also written an article published in Ekonomisk Debatt, and presented our work in policy seminars at Nationalekonomiska Föreningen, and Finanspolitiska rådet.