Asset Bubbles and Financial Frictions in Small Open Economies *

Abstract

Financial cycles involving asset bubbles frequently coincide with the cyclical expansion and contraction of credit conditions. The collapse of asset and credit bubbles frequently precedes financial crises and economic recessions. We develop a small open economy DSGE model that incorporates asset bubbles and financial frictions. Credit-constrained firms trade in intrinsically useless bubble assets. Financial intermediaries, constrained by their balance sheets, introduce friction into financial markets. The static analysis suggests that increases in foreign interest rates unfavorably impact the formation of domestic bubbles. Dynamic analysis indicates that asset bubbles amplify macroeconomic fluctuations, with frictions among financial intermediaries, intensifying this effect. Therefore, asset bubbles amplify and propagate economic fluctuations. Unconventional monetary policy, macroprudential policy, and bubbly bailout policy could mitigate the amplification effects of financial frictions and asset bubble bursts on macroeconomic fluctuations, which are mediated through reducing risk premiums, curbing capital outflows, and sustaining asset bubble channels, respectively. Finally, combining unconventional monetary policies with bubbly bailout policies and macroprudential policies yields superior outcomes.

Keywords: Asset Bubbles, Financial Frictions, Financial Accelerator, Small Open Economy, Policy Implications

JEL Classification: E44, E52, F30, F41, F44