Discussion Paper Series 2011-E-24

Bubbles, Banks, and Financial Stability

Kosuke Aoki, Kalin Nikolov

This paper asks two main questions: (1) What makes some asset price bubbles more costly for the real economy than others? and (2)When do costly bubbles occur? We construct a model of rational bubbles under credit frictions and show that when bubbles held by banks burst this is followed by a costly financial crisis. In contrast, bubbles held by ordinary savers have relatively muted effects. Banks tend to invest in bubbles when financial liberalisation decreases their profitability.

Keywords: Rational bubbles; Financial Frictions; Financial Stability


Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2011 Bank of Japan All Rights Reserved.

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