Limited enforcement, bubbles and trading in incomplete markets

Bejan, Camelia and Bidian, Florin (2010): Limited enforcement, bubbles and trading in incomplete markets.

Abstract

Rational bubbles are believed to be fragile and unable to explain the trading frenzy associated to price run-ups. With limited enforcement of credit contracts and endogenous debt limits designed to prevent default and allow for maximal credit expansion, a large class of bubbles can be introduced in asset prices by appropriately tightening agents' debt limits. By not affecting consumption, these bubbles are ideally suited to explain a variety of asset pricing puzzles. They can generate large increases in trade volume until they crash. Nonpositivity of debt limits restricts the potential for bubble injections to assets in zero supply or to equilibria with an infinite present value of aggregate endowment. Such equilibria are common in economies with limited enforcement, where interest rates are low to induce debt repayment (Bidian and Bejan 2012).

• Item Type: MPRA Paper
• Language: English
• Keywords: rational bubbles, limited enforcement, trade volume, equity premium puzzle, endogenous debt limits
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E50 - General

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