The Birth and Burst of Asset Price Bubbles∗

We develop a model of rational bubbles, based on the assumptions of an unknown potential market size (liquidity) and delegation of investment decisions. In a bub-ble, the price of an asset rises above its steady-state value, which must be justified by rational expectations about possible future price developments. The higher the expected future price increase, the more likely is the market potential reached, in which case the bubble will burst. Depending on the interaction of uncertainty about the market potential, fundamental riskiness of the asset, the compensation scheme of the fonds manager, and the risk-free interest rate, we give a condition for whether rational bubbles are possible. Based on this analysis, several widely-discussed policy measures are investigated with respect to their effectiveness to prevent bubbles. A modified Taylor rule, long-term compensation, and capital requirements can have the desired effect. Caps on bonuses and a Tobin tax can create or destroy the possibility of bubbles, depending on their implementation