1/2019 Jacopo Bonchi. Asset Price Bubbles with Low Interest Rates: Not All Bubbles are Alike
Working Papers of Eesti Pank 1/2019
I extend a standard two-period OLG model to investigate the interplay between the risks of a binding zero lower bound and asset price bubbles in a low interest rates environment. The nature of the bubble is crucial when the risk-free real interest rate
is low because there is a negative natural interest rate. Bubbles are fully leveraged when they are sustained by borrowers, or they are fully unleveraged when they are sustained by lenders. Leveraged bubbles emerge naturally when there is a negative
natural interest rate, and they are more likely to collapse. Unleveraged bubbles appear, in contrast, if the natural rate of interest is extremely low and the probability of the bubble bursting is not extremely high. Both bubbles are more likely to emerge
with a high inflation target and will potentially be larger, but only leveraged bubbles substantially mitigate the risk of a zero lower bound episode by raising the natural rate of interest.