Bankers ’ Bonuses and Speculative Bubbles∗

We develop a parsimonious model of bubbles based on the assumption of imprecisely known market depth. In a speculative bubble, bankers (traders) drive the price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. Bubbles reduce aggregate welfare; households are nevertheless willing to lend to bankers during the buildup of a bubble. We provide a general condition for the possibility of bubbles depending on the risk-free rate, uncertainty about market depth, banks ’ degree of leverage, and bankers ’ bonus structure. This allows us to discuss several policy measures. Among others, capping bonuses, minimum leverage ratios, monetary policy rules that react to asset prices, and a correctly implemented Tobin tax can prevent their occurrence. Implemented incorrectly, however, some of these measures—bonus regulations in particular—backfire and facilitate bubbles