DP11149 | Secular Stagnation, Rational Bubbles and Fiscal Policy

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03/02/2016

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Abstract

It is well known that rational bubbles can be sustained in a dynamically inefficient economy, where the return to capital r is below the growth rate g. However, empirical evidence suggests that modern economies are most of the time on an efficient path with r>g. This paper shows that rational bubbles can be sustained when r<g for some episodes only. Bubbly assets are shown to enhance efficiency, although they do not allow the implementation of first-best. Where r<g was considered a prerequisite for the existence of bubbles, we show that bubbles cause r>g "on average". Fiscal policy can enhance both welfare and financial stability. Contrary to common wisdom, trade in bubbly assets implements intergenerational transfers, while fiscal policy is needed for the implementation of intragenerational transfers. Finally, we show that in an economy with risk aversion, bubbles may emerge even when there exists an asset with a risk-free return growing at rate g.