Financial Market Globalization and Asset Price Bubbles

Abstract

We construct a two-country model of rational bubbles with asymmetric degrees of financial development. We show that whether financial globalization gives rise to bubbles crucially depends on the levels of financial development in the two countries. In economies with either developed or underdeveloped financial market relative to the foreign one, bubbles cannot arise under financial autarky but they can arise under financial globalization. Moreover, unlike previous literature, bubbles in sufficiently well-developed financial markets lead to welfare losses in other countries.

Keywords: Financial globalization, Asset bubbles, Credit friction

JEL Classification: E44, F32