Bubbly bailout

Abstract

We provide a theory to investigate the implications of time-varying bailout policy for rational bubbles in an infinite-horizon production economy. In particular, we ask two questions. First, should the government bailout asset bubbles? Second, if yes, how? In our model, firms face idiosyncratic investment opportunities and financial frictions, and creating new bubbles incurs real resources. Intrinsically useless assets can alleviate firms' credit constraints and enhance investment efficiency with additional liquidity. However, asset bubbles are vulnerable to market sentiment and resource-consuming. The time-varying probability of bubble burst causes both asset price volatility and economic fluctuations. In the presence of this tradeoff, we examine the efficiency and the welfare implications of the time-varying bailout policy. We find that the optimal bailout policy is leaning against the wind, striking a balance between the crowding-in and crowding-out effect.