During the past three decades, many countries have lifted restrictions on cross-border financial transactions. We present a simple model that can account for the observed effects of financial globalization. The model emphasizes the role of imperfect enforcement of domestic debts and the interactions between domestic and foreign debts. Financial globalization can lead to a variety of outcomes: (i) domestic capital flight and ambiguous effects on net capital flows, investment, and growth; (ii) capital inflows and higher investment and growth; or (iii) volatile capital flows and unstable domestic financial markets. The model shows how the effects of financial globalization depend on the level of development, productivity, domestic savings, and the quality of institutions.

What is the role of monetary policy in a bubbly world? To address this question, we study an economy in which financial frictions limit the supply of assets. The ensuing scarcity generates a demand for “unbacked” assets, i.e., assets that are backed only by the expectation of their future value. We consider two types of unbacked assets: bubbles, which are created by the private sector, and money, which is created by the central bank. Bubbles and money share many features, but they also differ in two crucial respects. First, while the rents from the creation of bubbles accrue to entrepreneurs and foster investment, the rents from money creation accrue to the central bank. Second, while bubbles are driven by market psychology, and can rise and fall according to the whims of the market, money is under the control of the central bank. We characterize the optimal monetary policy and show that, through its ability to supply assets, monetary policy plays a key role in the bubbly world. The model sheds light on the recent expansion of central bank liabilities in response to the bursting of bubbles.

Over the last two decades US aggregate wealth has fluctuated substantially. Against the backdrop of the Great Recession, the effects of these boom-and-bust cycles have come to dominate academic and policy discussions. How can we explain these fluctuations in wealth? Why are these fluctuations associated with changes in consumption, investment and output? In this note, we argue that answers to these questions entail the addition of two ingredients to existent macroeconomic models: rational bubbles and financial frictions. We explain why each of these building blocks is crucial to understand recent events and how they can be seamlessly integrated in standard models.