Working Paper

Rational Bubbles in Non-Linear Business Cycle Models: Closed and Open Economies

Abstract: This paper studies rational bubbles in non-linear dynamic general equilibrium models of the macroeconomy. The term ‘rational bubble’ refers to multiple equilibria due to the absence of a transversality condition (TVC) for capital. The lack of TVC can be due to an OLG population structure. If a TVC is imposed, the macro models considered here have a unique solution. Bubbles reflect self-fulfilling fluctuations in agents’ expectations about future investment. In contrast to explosive rational bubbles in linearized models (Blanchard (1979)), the rational bubbles in non-linear models here are bounded. Bounded rational bubbles provide a novel perspective on the drivers and mechanisms of business cycles. I construct bubbles (in non-linear models) that feature recurrent boom-bust cycles characterized by persistent investment and output expansions which are followed by abrupt contractions in real activity. Both closed and open economies are analyzed. In a non-linear two-country model with integrated financial markets, bubbles must be perfectly correlated across countries. Global bubbles may, thus, help to explain the synchronization of international business cycles.

Keywords: rational bubbles; boom-bust cycles; business cycles in closed and open economies; non-linear DSGE models; Long-Plosser model; Dellas model;

JEL Classification: E1; E3; F3; F4; C6;

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Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2020-02-11

Number: 378