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Bubbly bailout

Author

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  • Dong, Feng
  • Xu, Zhiwei

Abstract

We provide a theory to investigate the implications of time-varying bailout policy for rational bubbles in an infinite-horizon production economy. In particular, we ask two questions. First, should the government bailout asset bubbles? Second, if yes, how? In our model, firms face idiosyncratic investment opportunities and financial frictions, and creating new bubbles incurs real resources. Intrinsically useless assets can alleviate firms' credit constraints and enhance investment efficiency with additional liquidity. However, asset bubbles are vulnerable to market sentiment and resource-consuming. The time-varying probability of bubble burst causes both asset price volatility and economic fluctuations. In the presence of this tradeoff, we examine the efficiency and the welfare implications of the time-varying bailout policy. We find that the optimal bailout policy is leaning against the wind, striking a balance between the crowding-in and crowding-out effect.

Suggested Citation

  • Dong, Feng & Xu, Zhiwei, 2022. "Bubbly bailout," Journal of Economic Theory, Elsevier, vol. 202(C).
  • Handle: RePEc:eee:jetheo:v:202:y:2022:i:c:s0022053122000503
    DOI: 10.1016/j.jet.2022.105460
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    More about this item

    Keywords

    Asset bubbles; Financial risks; Bailout; Time-varying policy;
    All these keywords.

    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
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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