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Government Induced Bubbles

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  • Beteto, Danilo Lopomo

Abstract

We build a model of bubble inflation based on Morris and Shin (1998), with investors deciding whether or not to buy an asset that entails the risk of a collapse in prices, in which case only government intervention could make them avoid a substantial loss. The more investors decide to buy, the more the bubble inflates, and government intervention takes place only when the collapse in prices is sufficiently large. In the benchmark scenario of common knowledge, self-fulfilling beliefs lead to multiplicity of equilibria. Using a global games approach, the introduction of a small noise in the signal received by the speculators yields a unique equilibrium, with intervention occuring only if the state of fundamentals happens to be higher than a particular threshold. In a comparative static exercise, it is shown that the government is more likely to step in and bubbles be large the less liquid the asset and the higher the aggregate wealth of investors.

Suggested Citation

  • Beteto, Danilo Lopomo, 2012. "Government Induced Bubbles," Risk and Sustainable Management Group Working Papers 156476, University of Queensland, School of Economics.
    • Handle: RePEc:ags:uqsers:156476
    DOI: 10.22004/ag.econ.156476
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    References listed on IDEAS

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