Bubbles and Economic Fluctuations

This chapter studies the relationship between asset price bubbles and macroeconomic fluctuations through both empirical analysis and theoretical modeling. We begin by applying the right-tailed unit root tests of Phillips et al. (2015a,b) to real stock and housing price indices in G-7 economies. These tests identify explosive dynamics in asset prices, and our findings show that such bubbly episodes frequently align with periods of economic expansion, suggesting a strong empirical link between asset booms and business cycle upswings. To investigate the mechanisms behind this co-movement, we modify the canonical bubble models of Tirole (1985) and Martin and Ventura (2012) by incorporating endogenous labor supply. However, in both cases, the emergence of a bubble fails to generate a robust macroeconomic expansion. Output and investment either decline or respond sluggishly, while labor hours fall in response to bubble formation. We then turn to the model of Guerron-Quintana et al. (2023), which embeds a variable capacity utilization mechanism into a dynamic general equilibrium framework. This amplification channel allows the model to produce simultaneous increases in output, consumption, investment, and labor during bubbly periods, consistent with empirical patterns. We also discuss the quantitative implementation challenges faced by this approach, highlighting the trade-offs involved in quantitatively modeling bubble-driven fluctuations.