Bubbly Recessions (Revised January 2019)

We develop a tractable bubbles model with financial frictions and downward wage rigidity. Competitive speculation in risky bubbles can result in excessive investment booms that precede inefficient busts, where post-bubble aggregate economic activities collapse below the pre-bubble trend. Risky bubbles can reduce ex-ante social welfare, and leaning-against-the-bubble policies that balance the boom-bust trade-off can be warranted. We further show that the collapse of a bubble can push the economy into a "secular stagnation" equilibrium, where the zero lower bound and the nominal wage rigidity constraint bind, leading to a persistent recession, such as the Japanese "lost decades."