WP 2012-03 Limited enforcement, bubbles and trading in incomplete markets

AUTHORS: Camelia Bejan and Florin Bidian

ABSTRACT. Rational bubbles are believed to be fragile and unable to explain the trading frenzy associated to price run-ups. With limited enforcement of credit contracts and endogenous debt limits designed to prevent default and allow for maximal credit expansion, a large class of bubbles can be introduced in asset prices by appropriately tightening agents' debt limits. By not affecting consumption, these bubbles are ideally suited to explain a variety of asset pricing puzzles. They can generate large increases in trade volume until they crash. Nonpositivity of debt limits restricts the potential for bubble injections to assets in zero supply or to equilibria with an in nite present value of aggregate endowment. Such equilibria are common in economies with limited enforcement, where interest rates are low to induce debt repayment (Bidian and Bejan 2012).