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Deflationary Bubbles

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  • Buiter, Willem H
  • Sibert, Anne

Abstract

We analyse deflationary bubbles in a model where money is the only financial asset. We show that such bubbles are consistent with the household’s transversality condition if and only if the nominal money stock is falling. Our results are in sharp contrast to those in several prominent contributions to the literature, where deflationary bubbles are ruled out by appealing to a non-standard transversality condition, originally due to Brock ([4], [5]). This condition, which we dub the GABOR condition, states that the consumer must be indifferent between reducing his money holdings by one unit and leaving them unchanged and enjoying the discounted present value of the marginal utility of that unit of money forever. We show that the GABOR condition is not part of the necessary and sufficient conditions for household optimality nor is it sufficient to rule out deflationary bubbles. Moreover, it rules out Friedman’s optimal quantity of money equilibrium and, when the nominal money stock is falling, it rules out deflationary bubbles that are consistent with household optimality. We also consider economies with real and nominal government debt and small open economies where private agents can lend to and borrow from abroad. In these cases, deflationary bubbles may be possible, even when the nominal money stock is rising. Their existence is shown to depend on the rules governing the issuance of government debt.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4528.

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Date of creation: Aug 2004
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Handle: RePEc:cpr:ceprdp:4528

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Keywords: fiscal rules; government solvency; optimal quantity of money; transversality condition;

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References

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Citations

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Cited by:
  1. W.H. Buiter, 2007. "Is Numérairology the Future of Monetary Economics? Unbundling numéraire and medium of exchange through a virtual currency and a shadow exchange rate," CEP Discussion Papers dp0776, Centre for Economic Performance, LSE.
  2. Buiter, Willem H., 2009. "Negative nominal interest rates: Three ways to overcome the zero lower bound," The North American Journal of Economics and Finance, Elsevier, vol. 20(3), pages 213-238, December.
  3. Takashi Kamihigashi, 2007. "The Spirit of Capitalism, Stock Market Bubbles, and Output Fluctuations," Discussion Paper Series 205, Research Institute for Economics & Business Administration, Kobe University, revised Oct 2007.
  4. Ulrich van Suntum & Metin Kaptan & Cordelius Ilgmann, . "Reducing the lower bound on market interest rates," Working Papers 200103, Institute of Spatial and Housing Economics, Munster Universitary.
  5. Willem H. Buiter, 2004. "The Elusive Welfare Economics of Price Stability as a Monetary Policy Objective: Should New Keynesian Central Bankers Pursue Price Stability?," NBER Working Papers 10848, National Bureau of Economic Research, Inc.
  6. Buiter, Willem H, 2004. "Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap," CEPR Discussion Papers 4202, C.E.P.R. Discussion Papers.
  7. Óscar J. Arce, 2005. "Reflections on fiscalist divergent price-paths," Banco de España Working Papers 0533, Banco de España.
  8. Zhou, Ge, 2011. "Rational bubbles and the spirit of capitalism," MPRA Paper 33988, University Library of Munich, Germany.
  9. Willem H. Buiter, 2006. "The elusive welfare economics of price stability as a monetary policy objective - why New Keynesian central bankers should validate core inflation," Working Paper Series 609, European Central Bank.
  10. Willem Buiter, 2007. "Is Numérairology the Future of Monetary Economics?," Open Economies Review, Springer, vol. 18(2), pages 127-156, April.

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