Working Paper (21-006E) Bubbles, Crashes, and Economic Growth: Theory and Evidence

In order to account for the ups and downs in economic growth in recent decades, we construct a model with recurrent bubbles, crashes, and endogenous growth that can be easily taken to the data. Infinitely lived households expect future bubbles, which crowds out investment and reduces economic growth. For realized bubbles crowd in investment, their overall impact on economic growth and welfare crucially depends on both the level of financial development and the frequency of bubbles. We examine the US economic data through the lens of our model, finding evidence of bubbly episodes by structural estimation. Counterfactual simulations suggest that 1) the IT and housing bubbles together lifted U.S. GDP by almost 2 percentage points permanently; and 2) the U.S. economy could have grown even faster if people had believed that asset bubbles would not arise.