Market Depth, Leverage, and Speculative Bubbles

Abstract We develop a model of rational bubbles based on leverage and the assumption an imprecisely known maximum market size. In bubble, traders push asset price above its fundamental value in dynamic way, driven by expectations about future developments. At previously unknown date, bubble will endogenously burst. Households optimally decide whether to lend with limited liability. Bubbles increase welfare initial holders, but reduce households. provide general conditions for possibility depending uncertainty size, traders’ degree leverage, risk-free rate. This allows us discuss several policy measures. Capital requirements correctly implemented Tobin tax can prevent bubbles. Implemented incorrectly, however, these measures may create welfare.