Abstract
This paper introduces a new disturbing element, the bubble asset, into the basic financial accelerator model by Bernanke et al. (1999). Through a contract between an entrepreneur and a financial intermediary, the optimal leverage ratio becomes an increasing function of bubble surviving probability. Decline in a bubble asset's surviving probability shock affects an entrepreneur's optimal leverage ratio through the following two channels: depriving low productivity firms of a profit opportunity from bubble asset investment and pushing up the financial intermediaries' cost associated with bubble bust, leading to an increased external finance premium. Both channels result in a deterioration in entrepreneurial net worth, causing persistent and strong investment declines in the economy. Furthermore, simulation results show that an economy with higher bubble surviving probability at the steady state suffers from prolonged and severe stagnation from a bubble burst shock due to entrepreneurs' high deleverage and persistent net-worth deterioration.
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