Publication Type

Journal Article

Publication Date

9-2016

Abstract

We construct a model of asset market exuberance, collapse and recovery using subjective investor-based rational expectations about the impact of fundamentals on the market price. Investors are assumed to have heterogeneous market sentiments, allowing them to be exuberant, cautious, or fundamentalist via boundary conditions that describe their respective views of the market impact of the same economic fundamentals. Equilibrium solution paths of the model take varying forms, depending on the parameter settings that reflect the importance of each type of market participant. This rational expectations model of asset pricing is shown to be consistent with a simple explosive continuous time autoregression when exuberant sentiment dominates the market. The model explains asset price bubbles, including expansion and subsequent collapse, together with long-term recovery. Extensions of the model allow for contagion effects in which market sentiments are transmitted from a primary market to a secondary market, reproducing speculative behavior and corrections in the secondary market. Some of the implications of the model for empirical work are explored.

Keywords

Asset price bubble, Collapse, Contagion, Exuberance, Fundamentals, Heterogeneous agents, Smooth pasting

Discipline

Econometrics | Finance

Research Areas

Econometrics

Publication

Research in Economics

Volume

70

Issue

3

First Page

375

Last Page

387

ISSN

1090-9443

Identifier

10.1016/j.rie.2016.01.002

Publisher

Elsevier

Creative Commons License

Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License
This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License.

Additional URL

https://doi.org/10.1016/j.rie.2016.01.002

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