On the interplay between speculative bubbles and productive investment

Abstract

The aim of this paper is to study the interplay between long term productive investments and more short term and liquid speculative ones. A three-period lived overlapping generations model allows us to make this distinction. Agents have a portfolio decision. When young, they can invest in human capital that is a productive long term investment that provides a return during the following two periods. When young or in the middle age, they can invest in a bubble. Young individuals can also borrow on a credit market to finance the productive investment. However, the amount borrowed is limited by a credit constraint. We show that the existence of a stationary bubble raises productive investment and production when the bubleless economy is credit constrained and dynamically efficient. Indeed, young agents sell short the bubble to increase productive investments, whereas traders at middle age transfer wealth to old age. The bubble allows to relax the credit constraint. We outline that a permanent technological shock inducing either a larger return of capital in the short term or a similar increase in the return of capital in both periods raises productive capital, production and the bubble size. We use our framework to discuss the effect on the occurrence of bubbles of financial regulation and fiscal policy.