Bubbles and Total Factor Productivity

Evidence shows that asset price bubbles typically precede financial crises and financial crises are accompanied by the collapse of bubbles. In addition, stock market booms and busts are typically associated with credit market booms and busts. The recent US housing and stock market bubbles and the subsequent Great Recession that began in late 2007 provide an example. The stock market booms in the early 1990s and the subsequent Asian financial crisis in 1997 provide another example. There are also many other related episodes of financial crises in emerging economies. Motivated by these observations, Miao and Wang (2011a) propose a theory of credit-driven stock price bubbles. We show that a positive feedback loop mechanism generates stock price bubbles when firms borrow against the stock market value of their collateralized assets to finance investment. We assume that firms face stochastic investment opportunities and bubbles improve investment efficiency. We also study stochastic bubbles and policy implications. In the present paper, we apply the theory developed by Miao and Wang (2011a) to an environment in which firms face idiosyncratic productivity shocks and credit constraints. We show that both bubbleless and bubbly equilibria bubbles and financial crisis ‡