SMU SOE Seminar Series (September 11, 2024): Negative Bubbles

TOPIC:

ABSTRACT

We develop a macroeconomic model with credit frictions in which firms' ability to borrow depends on the value of their equity. Under irreversibility of capital investment, this frame-work admits negative asset price bubbles in addition to the positive ones emphasized in the literature. We show that, depending on the cost of seizing the firm in bankruptcy, negative bubbles may be contractionary or expansionary.

Expansionary negative bubbles arise due to two offsetting effects. Negative bubbles reduce overall collateral which is contractionary when credit constraints bind. However, the contraction in aggregate collateral encourages the production of tangible collateral (capital) which is expansionary. When capital is highly pledgeable and, therefore, good collateral, the second effect dominates, and negative bubbles expand real economic activity, leading to dynamic inefficiency.

Keywords: Financial Frictions, Negative Bubbles

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