Asset Bubbles and Bailout

Abstract

This paper theoretically investigates the relationship between asset price bubbles and bailout. We show that although bailout may mitigate adverse effects of bubbles'bursting ex-post, it is more likely to cause asset price bubbles by encouraging risk-taking behavior ex-ante. In other words, bubbles are more likely to occur, the more government bailout is anticipated. Moreover, when productivity is relatively low, the anticipated bailout accelerates bubbly booms and creates large bubbles, which results in a large scale government intervention when bubbles collapse. This suggests that bailout policy that aims at stabilizing the economy during bubble bursts ends up with increasing boom-bust cycles