Discussion Paper Series, University of Heidelberg, Department of Economics 567
We develop a parsimonious model of bubbles based on the assumption of imprecisely known market depth. In a speculative bubble, traders drive the price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. We provide a general condition for the possibility of bubbles depending on the risk-free rate, uncertainty about market depth, and traders’ degree of leverage. This allows us to discuss several policy measures. Bubbles always reduce aggregate welfare. Among others, certain monetary policy rules, minimum leverage ratios, and a correctly implemented Tobin tax can prevent their occurrence. Implemented incorrectly, however, some of these measures backﬁre and facilitate bubbles.