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On the Existence and Prevention of Speculative Bubbles

Enders, Zeno ; Hakenes, Hendrik Hakenes

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We develop a parsimonious model of bubbles based on the assumption of imprecisely known market depth. In a speculative bubble, traders drive the price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. We provide a general condition for the possibility of bubbles depending on the risk-free rate, uncertainty about market depth, and traders’ degree of leverage. This allows us to discuss several policy measures. Bubbles always reduce aggregate welfare. Among others, certain monetary policy rules, minimum leverage ratios, and a correctly implemented Tobin tax can prevent their occurrence. Implemented incorrectly, however, some of these measures backfire and facilitate bubbles.

Item Type: Working paper
Series Name: Discussion Paper Series, University of Heidelberg, Department of Economics
Volume: 0567
Place of Publication: Heidelberg
Date Deposited: 18 Jun 2014 11:49
Date: June 2014
Number of Pages: 40
Faculties / Institutes: The Faculty of Economics and Social Studies > Alfred-Weber-Institut for Economics
Subjects: 330 Economics
Uncontrolled Keywords: Bubbles, Rational Expectations, Market Depth, Liquidity, Financial Crises, Leveraged Investment, Bonuses, Capital Structure.
Schriftenreihe ID: Discussion Paper Series / University of Heidelberg, Department of Economics
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