Final Report Summary - ABEP (Asset Bubbles and Economic Policy) The main objective of this project is to develop a view of asset bubbles as a result of a pre-existing market failure, and produce an empirically relevant macroeconomic framework that allows us to address the following questions:(i) What is the relationship between bubbles and financial market frictions? Special emphasis is given to how the globalization of financial markets and the development of new financial products affect the size and effects of bubbles.(ii) What is the relationship between bubbles, economic growth and unemployment? The theory suggests the presence of virtuous and vicious cycles, as economic growth creates the conditions for bubbles to pop up, while bubbles create incentives for economic growth to happen.(iii) What is the optimal policy to manage bubbles? We need to develop the tools that allow policy makers to sustain those bubbles that have positive effects and burst those that have negative effects.The project has produced a number of scientific papers dealing with different aspects of these questions that have been published in prestigious international journals. This research has developed a new theory of asset and credit bubbles that emphasizes the role of collateral and its fluctuations. Its main implications are:1. Financial systems operate with two types of collateral, fundamental and bubbly. Fluctuations in both types of collateral generate boom-bust cycles in asset prices, credit, investment and growth. These fluctuations might be driven by traditional or fundamental shocks, but also by changes in investor sentiment or market expectations. Both types of shock affect the amounts of fundamental and bubbly collateral.2. Bubbly collateral raises equilibrium credit ("crowding-in") but diverts part of this credit away from investment ("crowding-out"). When bubbles are small, the crowding-in effect dominates and investment and output increase. When bubbles are large, the crowding out effect dominates and investment and output are low. There is therefore an "optimal" bubble size that trades off these two effects to maximize long-term output and consumption.3. Markets are generically unable to provide the optimal amount of bubbly collateral, but a lender of last resort can replicate the "optimal" bubble allocation by taxing credit when bubbly collateral is excessive and subsidizing it when it is insufficient. Such a policy can be characterized as leaning-against-the-wind, but not as a policy of preventing bubbles. It cannot be characterized as a bailout policy either, since the credit-market interventions that are required to implement it pay for themselves. These results provide a coherent and rich view of economic fluctuations driven by financial asset and credit bubbles, in which both fundamental and bubbly collateral play a key role. They also provide a useful blueprint to guide policy in dealing with credit bubbles.
