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Title: Bubbles and Crises in a Small Open Economy
Keywords: Asset Price Bubbles, Economic Crises, A Small Open Economy, Dynamical Economy, Financial Imperfection, Financial Regulations
Issue Date: 22-Sep-2011
Source: ATHAKRIT THEPMONGKOL (2011-09-22). Bubbles and Crises in a Small Open Economy. ScholarBank@NUS Repository.
Abstract: This thesis develops the model of bubbles in the price of durable investment goods in a small open economy incorporating the common elements from the observation of crises: optimism, price boom-bust episode, intense capital gain, over-construction and over-utilization of factory buildings (relative to the economy with no bubble), and severe recession. Permanent bubbles in durable investment goods require the growth rate of the world economy to be higher than a threshold which is at least equal to the world?s interest rate. This can occur if the world is suffering from inefficient investment or financial imperfection. This condition is stronger than normal condition required for bubbles elaborated in the literature: the growth rate of the economy must be at least equal to the interest rate which can occur if the world is suffering from inefficient investment or financial imperfection. The reason is because the supply of durable investment goods is endogenously influenced by bubbly price itself. Thereby, the value of bubbles grows faster than the rate of interest. Differently and strikingly, stochastic bubbles can always emerge in a small open economy. Since bubbles are expected to crash to the fundamental price level, bubbles are expected to be financially sustained by the large amount of international savings from the rest of the world in the form of capital inflow. Hence, stochastic bubbles can emerge even in the world with no growth. This shows how vulnerable a small open economy can be against stochastic bubbles. Next, the thesis furthers a study by introducing the bond-financing and the limited pledgeability. When bubbles grow, the pledgeable income increases and there is more credit provision. This positive feedback loop, known as balance-sheet effect, allows bubbles to grow further and makes the economy very sensitive to the movement of the asset price. In addition, bubbles encourage risk-neutral banks to become more risk-taking. Owing to the competition in credit market, banks are willing to raise the lending rate and grant the loan beyond the fundamental value of the pledgeable income at the cost of the default when bubbles crash. At last, the thesis offers the policy analysis. To prevent bubbles, the positive feedback loop between bubbles and an ability to borrow must be cut. Firstly, the first-best policy, which can prevent bubbles without affecting the fundamental price level, is recommended by regulating the degree of collateralization. When the degree of collateralization is ruled to maintain the ability to borrow at the fundamental value of the pledgeable income, bubbles can no longer emerge. The rationale is that bubbles induce more supply of bubbly assets and hence lower the fundamental price level. The policy thus ensures that the credit provision is decreased along the dynamics of bubbles and hence bubbles cannot eventually be sustained. Yet, this first-best policy requires the policymaker a deep knowledge of asset price which is hard to implement. Instead, the second-best policy is suggested. One realistic example of such policy is the imposition of the margin constraint. The margin constraint requires investors to finance bubbles proportionally by their own internal fund. If bubbles emerged, this required internal funding would outgrow the wage income and hence bubbles could not exist. Although such policy is easy to implement, the shortcoming is that it partially suppresses the fundamental of the economy since it overall limits the credit provision.
Appears in Collections:Ph.D Theses (Open)

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