DP8038 | Theoretical Notes on Bubbles and the Current Crisis

Publication Date

23/10/2010

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Abstract

We explore a view of the crisis as a shock to investor sentiment that led to the collapse of a bubble or pyramid scheme in financial markets. We embed this view in a standard model of the financial accelerator and explore its empirical and policy implications. In particular, we show how the model can account for: (i) a gradual and protracted expansionary phase followed by a sudden and sharp recession; (ii) the connection (or lack of connection!) between financial and real economic activity and; (iii) a fast and strong transmission of shocks across sectors and countries. We also use the model to explore the role of fiscal policy.