Bubbles in Stochastic Economies: Can They Cure Overaccumulation of Capital?

It is well known that bubbles possess the potential to increase economic welfare due to a reduction of capital accumulation in deterministic overlapping generations economies that are in a dynamically inefficient state. However, actual economies are stochastic, where the concept of dynamic efficiency has turned out to be a complex issue. This paper contributes in two ways. First, the model presented in this paper establishes that dynamic inefficiency is not a necessary condition for deterministic bubbles in a stochastic economy. Second, a simulation shows that although bubbles are unable to persist in the stochastic steady state, they can still cure overaccumulation of capital for a time long enough to cover agents’ relevant time horizon. Copyright Springer-Verlag Wien 2005bubbles, dynamic efficiency, capital overaccumulation, stochastic OLG model, D61, E44,