Asset bubbles, economic growth, and a self-fulfilling financial crisis

• A tractable dynamic general equilibrium model with asset bubbles is presented.
• Financial frictions allow asset bubbles to arise with infinitely lived agents.
• Two policies are investigated with analytical solutions for economic variables.
• The first policy avoids financial crises, supporting the presence of asset bubbles.
• The second policy avoids bubbles by taxing depositors and subsidizing investors.

A tractable model in which asset bubbles can exist in spite of infinitely lived agents is presented. An intrinsically useless asset has a positive value and raises welfare because it helps investors with idiosyncratic productivity to obtain more credit in imperfect financial markets. However, the bubbly equilibrium is only the second best. Moreover, bubbles may burst, and this leads to recessions. The model׳s analytical solution allows for the study of many policies. We find that a policy of purchasing the asset avoids financial crises but nevertheless results in the second-best outcome. A policy that taxes depositors and subsidizes investors both prevents crashes and achieves the first-best outcome.