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Capital Bubbles, Interest Rates, and Investment in a Small Open Economy

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  • TOMOO KIKUCHI
  • ATHAKRIT THEPMONGKOL

Abstract

We model a bubble in a productive asset (capital) on an explosive path, which diverges from the fundamental equilibrium and bursts with a positive probability. When the bubble grows, the small open economy borrows from the the world economy to finance investment and production, and banks charge the risk of the bubble bursting as an interest rate spread to debtors. Consequently, the interest rate spread widens as loans are increasingly backed by the bubble. When the bubble bursts, defaults cause a sudden stop of credit inflow from the world economy, investment falls, and the interest rate spread vanishes.

Suggested Citation

  • Tomoo Kikuchi & Athakrit Thepmongkol, 2020. "Capital Bubbles, Interest Rates, and Investment in a Small Open Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(8), pages 2085-2109, December.
    • Handle: RePEc:wly:jmoncb:v:52:y:2020:i:8:p:2085-2109
    DOI: 10.1111/jmcb.12723
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    References listed on IDEAS

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    Cited by:

    1. Luangaram, Pongsak & Thepmongkol, Athakrit, 2022. "Loan-to-value policy in a bubble-creation economy," Journal of Asian Economics, Elsevier, vol. 79(C).
    2. Takashi Kamihigashi & Ryonghun Im, 2022. "Two Types of Asset Bubbles in a Small Open Economy," Discussion Paper Series DP2022-15, Research Institute for Economics & Business Administration, Kobe University.

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