Bubbles and Crises
Posted: 11 Feb 1998
Date Written: November 1997
Bubbles where asset prices rise and then collapse are often followed by financial crises where default is widespread. A simple theory of bubbles based on an agency problem is developed. Investors use money borrowed from banks to invest. Risky assets are relatively attractive because investors can default in low payoff states so there is asset substitution and prices are bid up. The overall level of asset prices depends on the amount of credit. Risk can originate in both the real and financial sectors. Financial fragility occurs when credit expansion might be insufficient to ensure asset prices are high enough to prevent default.
JEL Classification: G12
Suggested Citation: Suggested Citation