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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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References

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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. Koulovatianos, Christos & Wieland, Volker, 2011. "Asset pricing under rational learning about rare disasters," IMFS Working Paper Series 46, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt.
  2. Hommes, C.H. & Zhu, M., 2012. "Behavioral Learning Equilibria," CeNDEF Working Papers 12-09, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  3. Klaus Adam & Pei Kuang & Albert Marcet, 2011. "House Price Booms and the Current Account," CEP Discussion Papers dp1064, Centre for Economic Performance, LSE.
  4. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 1-48 National Bureau of Economic Research, Inc.
  5. Klaus Adam & Albert Marcet, 2011. "Internal Rationality, Imperfect Market Knowledge and Asset Prices," CEP Discussion Papers dp1068, Centre for Economic Performance, LSE.
  6. Willi Semmler & Lucas Bernard, 2011. "Boom-Bust Cycles: Leveraging, Complex Securities, and Asset Prices," DEGIT Conference Papers c016_034, DEGIT, Dynamics, Economic Growth, and International Trade.
  7. Blake LeBaron, 2010. "Heterogeneous Gain Learning and Long Swings in Asset Prices," Working Papers 10, Brandeis University, Department of Economics and International Businesss School.
  8. Pei Kuang, 2013. "Imperfect Knowledge about Asset Prices and Credit Cycles," CDMA Working Paper Series 201303, Centre for Dynamic Macroeconomic Analysis.
  9. 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.
  10. 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.
  11. Pei Kuang, 2013. "Imperfect Knowledge About Asset Prices and Credit Cycles," Discussion Papers 13-02r, Department of Economics, University of Birmingham.
  12. repec:dgr:uvatin:2013014 is not listed on IDEAS
  13. 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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