We develop a stylized model of economic growth with bubbles in which changes in investor sentiment lead to the appearance and collapse of macroeconomic bubbles or pyramid schemes. These bubbles mitigate the effects of financial frictions. During bubbly episodes, unproductive investors demand bubbles while productive investors supply them. These transfers of resources improve economic efficiency thereby expanding consumption, the capital stock and output. When bubbly episodes end, there is a fall in consumption, the capital stock and output. We argue that the stochastic equilibria of the model provide a natural way of introducing bubble shocks into business cycle models.

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.