Effectiveness of Bailout Policies for Asset Bubbles in a Small Open Economy

Abstract

This study analyzes the effects of bailout policies on the growth rate and asset prices in a small open economy with asset bubbles. In our model, bubbles stimulate investment and economic activities (so-called "crowd-in effect' of bubbles). Thus, after bubble crushing occurs, recessions follow. Under this condition, we show that as long as bubbles persist, generous bailout policies raise the economic growth rate by enhancing the crowd-in effect. When bubbles burst, the bailout policy mitigates capital losses caused by the burst and accelerates economic growth and workers ' wages compared to the no-bailout case. Since the bailout policy has growth and recovery enhancing effects, a generous bailout policy is a desirable one for governments from the perspective of taxpayers ' welfare. It should be noted however, that a U.S. monetary policy to reduce the interest rate enlarges the size of asset bubbles in a small open economy, and further reduction of the U.S. interest rate makes the size of asset bubbles too large to be sustainable without adequate policy intervention of the small open economy; the government needs to reduce the scale of bailouts to an appropriate level in response to the U.S. interest rate reduction.