Bubbles, growth and sunspots with credit market frictions

This paper explores the role of bubbles in an overlapping-generations economy where some agents are more productive than the others. Due to missing credit markets, productive and unproductive agents cannot trade their financial assets to achieve mutual benefit, making the economy to perform below its potential. Introducing bubbles on the one hand crowds out some productive resources as it does in the current literature. It on the other hand may divert resources away from unproductive agents to productive ones. We find that bubbles are growth enhancing when the unproductive agents’ productivity level lies within an interval. Furthermore, in sharp contrast to the existing literature, the equilibrium bubble size is stable. This finding enables us to construct a two-state stationary sunspot equilibrium in which one state is associated with small bubbles and low growth whereas the other one has large bubbles and high growth. •Bubbles crowd out productive resources in an OLG model with financial frictions.•Bubbles re-allocate resources as productivity level of agents lies in an interval.•When the re-allocative effect dominates, bubbles are growth enhancing.•The equilibrium bubble size is unique and stable.•A two-state stationary sunspot equilibrium is found.