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Abstract
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.
Document type: | Working paper |
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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 |
DDC-classification: | 330 Economics |
Uncontrolled Keywords: | Bubbles, Rational Expectations, Market Depth, Liquidity, Financial Crises, Leveraged Investment, Bonuses, Capital Structure. |
Series: | Discussion Paper Series / University of Heidelberg, Department of Economics |