Bubbly Leverage Cycles *

Abstract

We propose a model of endogenous leverage cycles with asset bubbles in an infinite-horizon production economy. Entrepreneurs, heterogeneous in productivity, face leverage constraints due to moral hazard in credit markets. Bubble assets can attain value as they relax borrowing constraints. However, bubbles have both crowd-in and crowd-out effects, thereby either encouraging or hindering long-run growth. The model exhibits multiple dynamic equilibria, including endogenous boom-bust cycles with sudden collapse of credit markets despite the absence of adverse shocks. A leverage restriction policy can mitigate short-run fluctuations but impede long-run growth, while removing such a policy can deleverage the economy.

Keywords: Leverage Cycles, Endogenous Leverage, Asset Bubbles, Minsky Moment, Policy Implication

JEL Classification: E32; E51