Contagious Bubbles ‗

Abstract

This paper proposes a framework to study contagious stock price bubbles in a multi-industry economy with heterogeneous firms. Rational stock price bubbles arise endogenously under financial frictions to improve firms' equity positions and liquidation values. We characterize the full set of bubble equilibria and provide conditions under which the equity values of firms in different industries contain each other's bubbles. Particularly, a bubble burst in a critical industry can cause bubbles to burst in other industries, but not necessarily vice versa. We calibrate the financial linkages in our model using U.S. merger and acquisition data and show quantitatively that the financial industry is critical for the existence of contagious bubbles.

Keywords: Financial Networks, Asset Bubbles, Financial Contagion

JEL Classification: E2; E44; G1