A General Equilibrium Analysis Of The Government's Investment Bubble

Although the fixed capital investment is still running in a high level, government in all levels are promoting infrastructure investment, such as to enhance the urban construction. This study discusses the possibility that rational bubbles induced by government in infrastructure investment exist in a three-sector general equilibrium framework, and probes into the conditions, boom and bust mechanism, and the impact on the real economy. The enhancing effect of infrastructure on economic growth is obvious, but the growth rate of infrastructure capital stock deviating from its fundamentals may lead to the generation of rational bubbles, and this is what this study focuses in general equilibrium framework.Unlike behavioral bubbles (or speculative bubbles) which are conceived in bounded rations, rational bubbles could be represented with stochastic difference equations, equations with martingales and locomotive equations of bubbles. The application of this methodology in Diamond economy could explain rational bubbles of private capital stock, which deviates from the fundamentals determined by agent's saving behaviors.In the three-sector general equilibrium generated by introducing government into Diamond economy, assume that the government exposes taxes on the young in each period, and invests all the revenue on infrastructure, and infrastructure promotes output as the third factor. Analyses of the model reaches to a conclusion that rational bubbles can occurred in the government investment, and the characteristics, conditions of existence, boom and bust mechanism, and its possible impact on the economy are also studied.In order to eliminate government-generated bubbles, some measures can be taken to promote consumption so as to pull the economy to its dynamic efficient status, such as through enlarging the discount factor of consumers. Another approach for the government is that the government could invest part of its revenues on technology so as to improve the TFP and thus the total output. In so doing, without reducing consumption, a maximal output could be obtained, and thus dynamic efficiency achieved.Based on the theoretical analysis an empirical test on China's economy from 1978 to 2007 is applied, concluding that China's economy in that period is dynamic efficient, but the calculation of the fundamental value of the infrastructure stock indicates that the stock deviates from the fundamentals, proving the existence of rational bubbles.