Emerging market economies are fertile ground for the development of real estate and other financial bubbles. Despite these economies' significant growth potential, their corporate and government sectors do not generate the financial instruments to provide residents with adequate stores of value. Capital often flows out of these economies seeking these stores of value in the developed world. Bubbles are beneficial because they provide domestic stores of value and thereby reduce capital outflows while increasing investment. But they come at a cost, as they expose the country to bubble-crashes and capital flow reversals. We show that domestic financial underdevelopment not only facilitates the emergence of bubbles, but also leads agents to undervalue the aggregate risk embodied in financial bubbles. In this context, even rational bubbles can be welfare reducing. We study a set of aggregate risk management policies to alleviate the bubble-risk. We show that liquidity requirements, sterilization of capital inflows and structural policies aimed at developing public debt markets "collateralized" by future revenues, all have a high payoff in this environment.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
11618.
Length: Date of creation: Sep 2005 Date of revision: Handle: RePEc:nbr:nberwo:11618
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Find related papers by JEL classification: E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements F34 - International Economics - - International Finance - - - International Lending and Debt Problems F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
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