Managing Credit Bubbles

We study a dynamic economy where credit is limited by insu ¢ cient collateral and, as a result, investment and output are too low. In this environment, changes in investor sentiment or market expectations can give rise to credit bubbles, that is, expansions in credit that are backed not by expectations of future pro\u85ts (i.e. fundamental collateral), but instead by expectations of future credit (i.e. bubbly collateral). During a credit bubble, there is more credit available for entrepreneurs: this is the crowding-in e¤ect. But entrepreneurs must also use some of this credit to cancel past credit: this is the crowding-out e¤ect. There is an optimalbubble size that trades o ¤ these two e¤ects and maximizes long-run output and consumption. The equilibriumbubble size depends on investor sentiment, however, and it typically does not coincide with the optimalbubble size. This provides a new rationale for macroprudential policy. A lender of last resort can replicate the optimalbubble by taxing credit when the equilibrium bubble is too high, and subsidizing credit when the equilibriumbubble is too low. This leaning-against-the-wind policy maximizes output and consumption. Moreover, the same conditions tha