Bubbles, banks and financial stability

The macroeconomic impact of rational bubbles in a limited commitment economy crucially depends on whether banks or ordinary savers hold the bubble. Banks hold the bubble asset when their leverage is high, when long-term real interest rates are low or when lax supervision allows them to enjoy high deposit insurance subsidies. When banks are the bubble-holders, this amplifies the output boom by reducing loan-deposit rate spreads while the bubble survives but also deepens the recession when the bubble bursts. In contrast, the real impact of bubbles held by ordinary savers is more muted.