DP8924 Understanding Bubbly Episodes

Author(s): Vasco M Carvalho , Alberto Martin , Jaume Ventura

Publication Date: April 2012

Keyword(s): bubbly episodes , dynamic inefficiency , economic growth , financial frictions , bubbles

JEL(s): E32 , E44 , O40

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP8924.asp

Over the last two decades U.S. aggregate wealth has fluctuated substantially. Against the backdrop of the Great Recession, the effects of these boom-and-bust cycles have come to dominate academic and policy discussions. How can we explain these fluctuations in wealth? Why are these fluctuations associated with changes in consumption, investment and output? In this note, we argue that answers to these questions entail the addition of two ingredients to existent macroeconomic models: rational bubbles and financial frictions. We explain why each of these building blocks is crucial to understand recent events and how they can be seamlessly integrated in standard models