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ABEP — Result In Brief

Project ID: 249588
Funded under: FP7-IDEAS-ERC
Country: Spain

The macroeconomic effects of asset bubbles

The large and persistent movements in asset prices experienced by advanced capitalist economies cannot be justified with economic fundamentals. The dominant perception indicates that bubbles are a market failure, caused by some form of individual irrationality.
The macroeconomic effects of asset bubbles
EU-funded researchers took a different study approach based on the assumption that market participants are individually rational, without however negating that this might lead to collective suboptimal results.

ABEP (Asset bubbles and economic policy) aimed to develop a perception of asset bubbles resulting from pre-existing market failure, and produce an empirically relevant macroeconomic framework. They developed three questions in the context of the project.

The first question concerned the relationship between bubbles and financial market frictions, emphasising the ways that globalisation of financial markets and the development of new financial products affect the size and effects of bubbles.

Second, researchers examined the relationships among bubbles, investment and economic growth. They started from the hypothesis that virtuous and vicious cycles, as economic growth, create the conditions for bubbles to pop up, while bubbles create incentives for economic development.

The third question sought to find the optimal policy to manage bubbles, to help develop the tools to allow policymakers to sustain positive-effect bubbles and burst the ones with negative effects.

Project fellows developed a new theory of asset and credit bubbles that emphasises the role of collateral and its fluctuations, with three main implications.

First, financial systems operate with two types of collateral: fundamental and bubbly. In both cases, fluctuations – driven by traditional or fundamental shocks – generate boom-bust cycles in asset prices, credit investment and growth.

Second, bubbly collateral raises equilibrium credit (crowding-in), but turns away part of this credit from investment (crowding-out). Crowding-in is dominant when bubbles are small, while there is an increase in investment and output. On the other hand, large bubbles result in crowding-out and low investment and output. An optimal bubble size maximises long-term output and consumption.

Finally, lenders of last resort fill the markets' weaknesses to provide the optimal amount of bubbly collateral. They do so by replicating the optimal bubble allocation by taxing credit when bubbly collateral is excessive and subsidizing it when it's insufficient. This policy cannot be characterised as preventing bubbles or as a bailout policy.

Project outputs have been published in articles in international journals and provide a coherent and rich perspective of economic fluctuations driven by financial assets and credit bubbles.

Related information


Asset bubbles, asset prices, market failure, ABEP, economic policy, financial market
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