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Theoretical Notes On Bubbles And The Current Crisis

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Executive Summary

The authors explore a view of the crisis as a shock to investor sentiment that led to the collapse of a bubble or pyramid scheme in financial markets. They embed this view in a standard model of the financial accelerator and explore its empirical and policy implications. In particular, they show how the model can account for: a gradual and protracted expansionary phase followed by a sudden and sharp recession; the connection (or lack of connection!) between financial and real economic activity and; a fast and strong transmission of shocks across countries. They also use the model to explore the role of fiscal policy.

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