A Leverage-based Model of Speculative Bubbles (REVISED July 2013)
This paper examines whether theoretical models of bubbles based on the notion that the price of an asset can deviate from its fundamental value are useful for understanding historical episodes that are often described as bubbles, and which are distinguished by features such as asset price booms and busts, speculative trading, and seemingly easy credit terms. In particular, I focus on risk-shifting models similar to those developed in Allen and Gorton (1993) and Allen and Gale (2000). I show that such models could give rise to these phenomena, and discuss under what conditions price booms and speculative trading would emerge. In addition, I show that these models imply that speculative bubbles can be associated with low spreads between borrowing rates and the risk free rate, in accordance with observations on credit conditions during historical episodes often suspected to be bubbles.