Recurrent Bubbles and Economic Growth

Abstract

Some financial crises are preceded by the collapse of bubbles and followed by a long-lasting economic slump, the Great Recession being a recent example. To account for these features in the data, we develop a novel model of recurrent bubbles with endogenous growth, infinitely lived households, and financial frictions. Bubbles, once realized, promote economic growth because they provide liquidity to constrained investors. On the other hand, expectations about future bubbles crowd out investment, thereby reducing economic growth. With these competing e¤ects, the overall impact of recurrent bubbles, especially high-frequency bubbles, on economic growth and welfare depends on economic fundamentals. In economies with relatively developed (under-developed) financial markets, recurrent bubbles reduce (raise) the average economic growth and welfare compared to those situations where bubbles never materialize. We exploit these insights to map our model to the U.S. data for the period 1984 – 2017. The main findings from the empirical exercise are: 1) there is evidence of recurrent bubbles; 2) the asset price bubble fueled growth in the pre-Great Recession years; and 3) the bursting of the bubble is partially responsible for the post-Great Recession lukewarm recovery.