Bubbles and Collateral

We construct a model of bubbles where an asset can be used as collateral primarily due to higher-order uncertainty: while both a lender and a borrower know that the intrinsic value of the asset is low, they may still believe that a "greater fool" exists who will purchase it at a much higher price. We show that such bubbles can lead to inefficient overinvestment under certain conditions. Using this framework, we also examine the impacts of macroprudential policies, as well as other regulatory measures such as interest rate hikes and the resolution of uncertainty.