Bubbles and Capital Flows

Abstract: This paper presents a stylized model of international trade and asset price bubbles. Its central insight is that bubbles tend to appear and expand in countries where productivity is low relative to the rest of the world. These bubbles absorb local savings, eliminating inefficient investments and liberating resources that are in part used to invest in high productivity countries. Through this channel, bubbles act as a substitute for international capital flows, improving the international allocation of investment and reducing rate-of-return differentials across countries. This view of asset price bubbles has important implications for the way we think about economic growth and fluctuations. It also provides a simple account of some real world phenomena that have been difficult to model before, such as the recurrence and depth of financial crises or their puzzling tendency to propagate across countries.