Capital Bubbles, Interest Rates, and Investment in a Small Open Economy

Tomoo Kikuchi, Athakrit Thepmongkol

Research output: Contribution to journalArticlepeer-review

Abstract

We model a bubble in a productive asset (capital) on an explosive path, which diverges from the fundamental equilibrium and bursts with a positive probability. When the bubble grows, the small open economy borrows from the the world economy to finance investment and production, and banks charge the risk of the bubble bursting as an interest rate spread to debtors. Consequently, the interest rate spread widens as loans are increasingly backed by the bubble. When the bubble bursts, defaults cause a sudden stop of credit inflow from the world economy, investment falls, and the interest rate spread vanishes.

Original languageEnglish
Pages (from-to)2085-2109
Number of pages25
JournalJournal of Money, Credit and Banking
Volume52
Issue number8
DOIs
Publication statusPublished - 2020 Dec
Externally publishedYes

Keywords

  • default risk
  • financial crisis
  • financial regulation
  • interest rate spreads
  • rational bubbles
  • small open economy

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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