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Capital Bubbles, Interest Rates, and Investment in a Small Open Economy
Author(s) -
KIKUCHI TOMOO,
THEPMONGKOL ATHAKRIT
Publication year - 2020
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/jmcb.12723
Subject(s) - interest rate , economics , monetary economics , bubble , investment (military) , economic bubble , capital (architecture) , real interest rate , default , small open economy , monetary policy , finance , mechanics , geography , physics , archaeology , politics , political science , law
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.