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Managing Credit Bubbles

Listed author(s):
  • Alberto Martín
  • Jaume Ventura

We study a dynamic economy where credit is limited by insufficient collateral and, as a result, investment and output are too low. In this environment, changes in investor sentiment or market expectations can give rise to credit bubbles, that is, expansions in credit that are backed not by expectations of future profits (i.e. fundamental collateral), but instead by expectations of future credit (i.e. bubbly collateral). Credit bubbles raise the availability of credit for entrepreneurs: this is the crowding-in effect. But entrepreneurs must also use some of this credit to cancel past credit: this is the crowding-out effect. There is an "optimal" bubble size that trades off these two effects and maximizes long-run output and consumption. The equilibrium bubble size depends on investor sentiment, however, and it typically does not coincide with the "optimal" bubble size. This provides a new rationale for macroprudential policy. A credit management agency (CMA) can replicate the "optimal" bubble by taxing credit when the equilibrium bubble is too high and subsidizing credit when the equilibrium bubble is too low. This leaning-against-the-wind policy maximizes output and consumption. Moreover, the same conditions that make this policy desirable guarantee that a CMA has the resources to implement it.

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File URL: http://www.barcelonagse.eu/sites/default/files/working_paper_pdfs/823.pdf
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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 823.

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Date of creation: Mar 2015
Handle: RePEc:bge:wpaper:823
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  1. Stijn Claessens & M. Ayhan Kose & Marco E. Terrones, 2011. "Financial Cycles: What? How? When?," NBER International Seminar on Macroeconomics, University of Chicago Press, vol. 7(1), pages 303-344.
  2. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2006. "Bubbles and capital flow volatility: Causes and risk management," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 35-53, January.
  3. Aoki, Kosuke & Nikolov, Kalin, 2015. "Bubbles, banks and financial stability," Journal of Monetary Economics, Elsevier, vol. 74(C), pages 33-51.
  4. Bas B. Bakker & Giovanni Dell'Ariccia & Luc Laeven & Jérôme Vandenbussche & Deniz O Igan & Hui Tong, 2012. "Policies for Macrofinancial Stability; How to Deal with Credit Booms," IMF Staff Discussion Notes 12/06, International Monetary Fund.
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