I develop an OLG model with population growth in order to show how bubbles can prevent secular stagnation, despite structural changes putting downward pressure on the interest rates. This result sheds light on the US economic performance before the 2007-2008 crisis, which was characterized by falling interest rates, asset price bubbles and the absence of zero lower bound (ZLB) episodes.
Financial bubbles affects the real interest rate through two channels. Firstly, they are store of value (¿saving channel¿) and the presence of an alternative investment vehicle decreases savings. Secondly, they serve as a collateral (¿borrowing channel¿) in the credit market. This, on the one hand, stimulates the demand for borrowing of young households. On the other hand, it reduces savings by increasing the debt of middle-aged households. Overall, these effects determine an higher real interest rate in a bubbly economy than in a bubbleless one. This prevents the central bank from hitting the ZLB, when a permanent shock occurs
Even though there is an extensive literature on the secular stagnation and rational bubbles, to the best of my knowledge, this is the first work that tries to combine the insights from these two strands to interpret the events preceding the Great Recession.
Most of the works on the secular stagnation tries to interpret the current economic environment as the begin of a new era characterized by low output and inflation, but it does not provide an explanation for the US macroeconomic performance before the 2007-2008 crisis. In particular, it completely neglects the interaction between low rates and financial bubbles, which is at the core of my analysis.
At the same time, the literature on rational bubbles explores the possible implications of financial bubbles during ZLB episodes (e.g. Asyrian et al., 2016). However, these works do not allow for a permanent ZLB and don¿t explicitly model the cause of the ZLB episode.
Reference
Asriyan, Vladimir, Luca Fornaro, Alberto Martín and Jaume Ventura. 2016. ¿Monetary Policy for a Bubbly World¿, mimeo.