Rational Bubbles in Non-Linear Business Cycle Models: Closed and Open Economies

This paper studies rational bubbles in non-linear dynamic general equilibrium models of
the macroeconomy. The term ‘Rational bubble’ refers to multiple equilibria due to the
absence of a transversality condition (TVC) for capital. The lack of TVC can be due to an
OLG population structure. If a TVC is imposed, the macro models considered here have
a unique solution. Bubbles reflect self-fulfilling fluctuations in agents’ expectations about
future investment. In contrast to explosive rational bubbles in linearized models
(Blanchard (1979)), the rational bubbles in non-linear models here are bounded.
Bounded rational bubbles provide a novel perspective on the drivers and mechanisms of
business cycles. I construct bubbles (in non-linear models) that feature recurrent boombust
cycles characterized by persistent investment and output expansions which are
followed by abrupt contractions in real activity. Both closed and open economies are
analyzed. In a non-linear two-country model with integrated financial markets, bubbles
must be perfectly correlated across countries. Global bubbles may, thus, help to explain
the synchronization of international business cycles.