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Abstract
We build a model of bubble inflation based on Morris and Shin (1998), with
investors deciding whether or not to buy an asset that entails the risk of a collapse
in prices, in which case only government intervention could make them avoid a substantial
loss. The more investors decide to buy, the more the bubble inflates, and
government intervention takes place only when the collapse in prices is sufficiently
large. In the benchmark scenario of common knowledge, self-fulfilling beliefs lead
to multiplicity of equilibria. Using a global games approach, the introduction of a
small noise in the signal received by the speculators yields a unique equilibrium,
with intervention occuring only if the state of fundamentals happens to be higher
than a particular threshold. In a comparative static exercise, it is shown that the
government is more likely to step in and bubbles be large the less liquid the asset
and the higher the aggregate wealth of investors.