On the Desirability of Bubbles!

I would not have thought about whether bubbles are desirable or not given the current crisis. But one of the many things I admire about economists is that they are not afraid of heretic thought experiments. Some implications of Narayana Kocherlakota’s this paper certainly fall in this category.

He uses a model similar to the Kiyotaki-Moore model (2008) to account for the dramatic fall in firms’ networth and and employment in the aftermath of the financial crisis. In his model firms lend and borrow using land as collateral. The model is then used to analyze what causes bubbles in land price and what are welfare consequences of a bubble burst.

One of the implication of the model is that agents would prefer an unstable asset price bubble to no buuble at all. This happens becasue a bubble typically relaxes borrowing constraints allowing a lot more people to borrow and consume more than otherwise. This makes bubbles desirable and so the important question then becomes can government do something to sustain a bubble?

What should be the policy initiatives to respond to a crash? The model implies that even though in the long run putting money in hands of workers or firms is equivalent, in the short run it pays to give the money to firms rather than workers. This is because firm borrowing and lending plays an essential role in allocating capital to its efficient uses.  So here we have another argument against fiscal stimulus.

PS: Narayana Kocherlakota is now the President of the Minneapolis Fed!

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Filed under current economic issues, macroeconomics

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