Theoretical Notes on Bubbles and the Current Crisis

This paper explores a view of the crisis as a shock to investor sentiment that led to the collapse of a bubble or pyramid scheme in financial markets. The paper embeds this view in a standard model of the financial accelerator and explores its empirical and policy implications. In particular, it shows how the model can account for: (i) a gradual and protracted expansionary phase followed by a sudden and sharp recession; (ii) the connection (or lack of connection!) between financial and real economic activity; and (iii) a fast and strong transmission of shocks across countries. The paper also uses the model to explore the role of fiscal policy.