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Booms and Busts in Asset Prices

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  • Klaus Adam
  • Albert Marcet

Abstract

We show how low-frequency boom and bust cycles in asset prices can emerge from Bayesian learning by investors. Investors rationally maximize infinite horizon utility but hold subjective priors about the asset return process that we allow to differ infinitesimally from the rational expectations prior. Bayesian updating of return beliefs then gives rise to selfreinforcing return optimism that results in an asset price boom. The boom endogenously comes to an end because return optimism causes investors to make optimistic plans about future consumption. The latter reduces the demand for assets that allow to intertemporally transfer resources. Once returns fall short of expectations, investors revise return expectations downward and set in motion a self-reinforcing price bust. In line with available survey data, the learning model predicts return optimism to comove positively with market valuation. In addition, the learning model replicates the low frequency behavior of the U.S. price dividend ratio over the period 1926-2006.

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Bibliographic Info

Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1059.

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Date of creation: Jul 2011
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Handle: RePEc:cep:cepdps:dp1059

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Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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Keywords: asset price fluctuations; boom and bust cycles;

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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Riots, sell-offs & cascades
    by chris dillow in Stumbling and Mumbling on 2011-08-09 13:59:23
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Cited by:
  1. Alessandro Spelta & Guido Ascari & Nicolò Pecora, 2012. "Boom and Burst in Housing Market with Heterogeneous Agents," Quaderni di Dipartimento 177, University of Pavia, Department of Economics and Quantitative Methods.
  2. Klaus Adam & Pei Kuang & Albert Marcet, 2011. "House Price Booms and the Current Account," NBER Working Papers 17224, National Bureau of Economic Research, Inc.
  3. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Working Papers 17301, National Bureau of Economic Research, Inc.
  4. Klaus Adam & Albert Marcet, 2011. "Internal Rationality, Imperfect Market Knowledge and Asset Prices," CEP Discussion Papers dp1068, Centre for Economic Performance, LSE.
  5. Koulovatianos, Christos & Wieland, Volker, 2011. "Asset Pricing under Rational Learning about Rare Disasters," CEPR Discussion Papers 8514, C.E.P.R. Discussion Papers.
  6. John C. Williams, 2011. "Monetary policy in an era of crises," Speech, Federal Reserve Bank of San Francisco, issue Nov 11.
  7. Broer, Tobias & Kero, Afroditi, 2011. "Great Moderation or Great Mistake: Can rising confidence in low macro-risk explain the boom in asset prices?," CEPR Discussion Papers 8700, C.E.P.R. Discussion Papers.
  8. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.
  9. Scheffknecht, Lukas & Geiger, Felix, 2011. "A behavioral macroeconomic model with endogenous boom-bust cycles and leverage dynamcis," FZID Discussion Papers 37-2011, University of Hohenheim, Center for Research on Innovation and Services (FZID).

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