A Model of Leveraged Bubbles

Recessions that follow asset price booms accompanied by high credit growth are deeper and longer-lasting than those following asset price booms without strong debt accumulation. We develop a dynamic general equilibrium model with a rational asset bubble and an occasionally binding borrowing constraint that reproduces these empirical regularities. The bubble raises collateral values and relaxes borrowing limits during upswings, but tightens them when it bursts. We derive the time-consistent optimal policy and characterize simple borrowing-tax rules approximating it, showing such policies substantially reduce frequency and severity of recessions triggered by bursting of leveraged bubbles.