ECB LAMFALUSSY FELLOWSHIP                                 WORKING PAPER SERIES
                                                                                                                                     PROGRAMME                                                          NO 1348 / JUNE 2011
                                                                                                                             THEORETICAL NOTES 
                                                                                                                             ON BUBBLES AND 
                                                                                                                             THE CURRENT CRISIS
                                                                                                                             by Alberto Martin
                                                                                                                             and Jaume Ventura
                                                        WORKING PAPER SERIES
                                                                       NO 1348 / JUNE 2011
                                                                         ECB LAMFALUSSY FELLOWSHIP
                                                                                PROGRAMME
                                                    THEORETICAL NOTES ON BUBBLES 
                                                                                                  1
                                                              AND THE CURRENT CRISIS 
                                                                                    by Alberto Martin 
                                                                                                  2
                                                                                  and Jaume Ventura 
                                                       NOTE: This Working Paper should not be reported as representing 
                                                                    the views of the European Central Bank (ECB). 
                                                                     The views expressed are those of the authors 
                                                                   and do not necessarily reflect those of the ECB.
                                     In 2011 all ECB
                                       publications
                                      feature a motif
                                        taken from
                                    the €100 banknote.
                                     This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science 
                                                     Research Network electronic library at http://ssrn.com/abstract_id=1847663.
                               1   We dedicate this research to the memory of Paul Samuelson, the best economist of the twentieth century, and the first one to understand that 
                                   pyramid schemes are possible and might raise welfare even if we are all rational and well informed. We thank Fernando Broner, Francesco 
                                          Caselli, Pierre-Olivier Gourinchas and Chris Telmer for comments on an earlier draft, and Roger Farmer, Nobu Kiyotaki, 
                                                Hélène Rey and Stavros Panageas for very helpful discussions. We also thank Gonçalo Pina and Robert Zymek 
                                                              for excellent research assistance. This paper has been prepared by the authors 
                                                                     under the Lamfalussy Fellowship Program sponsored by the ECB.
                                                  2   Both authors: CREI and Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005-Barcelona, Spain; 
                                                                            e-mails: amartin@crei.cat and jventura@crei.cat
                                             Lamfalussy Fellowships 
                 This paper has been produced under the ECB Lamfalussy Fellowship programme. 
                 This programme was launched in 2003 in the context of the ECB-CFS Research 
                 Network on “Capital Markets and Financial Integration in Europe”. It aims at 
                 stimulating high-quality research on the structure, integration and performance of the 
                 European financial system. 
                 The Fellowship programme is named after Baron Alexandre Lamfalussy, the first 
                 President of the European Monetary Institute. Mr Lamfalussy is one of the leading 
                 central bankers of his time and one of the main supporters of a single capital market 
                 within the European Union.
                 Each year the programme sponsors five young scholars conducting a research project 
                 in the priority areas of the Network. The Lamfalussy Fellows and their projects are 
                 chosen by a selection committee composed of Eurosystem experts and academic 
                 scholars. Further information about the Network can be found at http://www.eu-
                 financial-system.org and about the Fellowship programme under the menu point 
                 “fellowships”. 
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                                                                           CONTENTS
                                                                           Abstract                                              4
                                                                           Summary                                               5
                                                                           1  A canonical model of fi nancial frictions 
                                                                               and business cycles                               9
                                                                               1.1 Basic setup                                   9
                                                                               1.2  Looking to the crisis through the lens 
                                                                                    of the canonical model                      14
                                                                           2  Bubbles as pyramid schemes                        17
                                                                               2.1  Setup with bubbles                          17
                                                                               2.2 Bubbly episodes                              19
                                                                               2.3  Looking to the crisis through the lens 
                                                                                    of the canonical model, again               22
                                                                           3 Policy implications                                23
                                                                               3.1  Setup with a government                     24
                                                                               3.2  ‘Undoing’ the crisis?                       27
                                                                           4 International transmission                         29
                                                                               4.1  A reinterpretation of the model             30
                                                                               4.2 International transmission                   31
                                                                           5 Concluding remarks                                 34
                                                                           References                                           36
                                                                           Tables and fi gures 38
                                                                                                                                   ECB
                                                                                                                   Working Paper Series No 1348
                                                                                                                               June 2011
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