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Beauty Contests and Irrational Exuberance: A Neoclassical Approach

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  • George-Marios Angeletos
  • Guido Lorenzoni
  • Alessandro Pavan

Abstract

The arrival of new, unfamiliar, investment opportunities is often associated with “exuberant” movements in asset prices and real economic activity. During these episodes of high uncertainty, financial markets look at the real sector for signals about the profitability of the new investment opportunities, and vice versa. In this paper, we study how such information spillovers impact the incentives that agents face when making their real economic decisions. On the positive front, we find that the sensitivity of equilibrium outcomes to noise and to higher-order uncertainty is amplified, exacerbating the disconnect from fundamentals. On the normative front, we find that these effects are symptoms of constrained inefficiency; we then investigate policies that can improve welfare in our model without any informational advantage on the government's part. At the heart of these results is a distortion that induces a conventional neoclassical economy to behave as a Keynesian “beauty contest” and to exhibit fluctuations that may look like “irrational exuberance” to an outside observer.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15883.

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Date of creation: Apr 2010
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Handle: RePEc:nbr:nberwo:15883

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  1. Alessandro Pavan & George-Marios Angeletos, 2008. "Policy with Dispersed Information," 2008 Meeting Papers 1103, Society for Economic Dynamics.
  2. Davidson, Malcolm & Gorton, Gary B, 1995. "Stock Market Efficiency and Economic Efficiency: Is There a Connection?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1261, C.E.P.R. Discussion Papers.
  3. George-Marios Angeletos & Alessandro Pavan, 2007. "Efficient Use of Information and Social Value of Information," Econometrica, Econometric Society, Econometric Society, vol. 75(4), pages 1103-1142, 07.
  4. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2007. "Wall Street and Silicon Valley: A Delicate Interaction," NBER Working Papers 13475, National Bureau of Economic Research, Inc.
  5. repec:bla:restud:v:77:y:2010:i:1:p:305-338 is not listed on IDEAS
  6. Manuel Amador & Pierre Olivier Weill, 2008. "Learning from Prices: Public Communication and Welfare," 2008 Meeting Papers 390, Society for Economic Dynamics.
  7. David P. Myatt & Chris Wallace, 2009. "Endogenous Information Acquisition in Coordination Games," Economics Series Working Papers 445, University of Oxford, Department of Economics.
  8. Gilchrist, Simon & Himmelberg, Charles P. & Huberman, Gur, 2005. "Do stock price bubbles influence corporate investment?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(4), pages 805-827, May.
  9. Franck Portier & Aude Pommeret & Olivier Loisel, 2008. "Monetary policy and herd behavior in new-tech investment," 2008 Meeting Papers 444, Society for Economic Dynamics.
  10. Bartosz Mackowiak & Mirko Wiederholt, 2004. "Optimal Sticky Prices under Rational Inattention," SFB 649 Discussion Papers SFB649DP2005-040, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany, revised Jul 2005.
  11. Christian Hellwig & Laura Veldkamp, 2009. "Knowing What Others Know: Coordination Motives in Information Acquisition," Review of Economic Studies, Oxford University Press, vol. 76(1), pages 223-251.
  12. Itay Goldstein & Emre Ozdenoren & Kathy Yuan, 2011. "Trading Frenzies and their Impact on Real Investment," FMG Discussion Papers, Financial Markets Group dp670, Financial Markets Group.
  13. Laura Veldkamp, 2003. "Media Frenzies in Markets for Financial Information," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 03-20, New York University, Leonard N. Stern School of Business, Department of Economics.
  14. Dupor, Bill, 2005. "Stabilizing non-fundamental asset price movements under discretion and limited information," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(4), pages 727-747, May.
  15. Christian Hellwig, . "Monetary Business Cycle Models: Imperfect Information (Review Article, March 2006)," UCLA Economics Online Papers, UCLA Department of Economics 377, UCLA Department of Economics.
  16. Amador, Manuel & Weill, Pierre-Olivier, 2006. "Learning from Private and Public Observation of Other's Actions," MPRA Paper 109, University Library of Munich, Germany.
  17. Itay Goldstein & Alexander Guembel, 2008. "Manipulation and the Allocational Role of Prices," Review of Economic Studies, Oxford University Press, vol. 75(1), pages 133-164.
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Cited by:
  1. Kathy Yuan & Emre Ozdenoren & Itay Goldstein, 2010. "Trading Frenzies and Their Impact on Real Investment," 2010 Meeting Papers, Society for Economic Dynamics 94, Society for Economic Dynamics.
  2. Tinn, K & Vourvachaki, E, 2013. "Can overpricing of technology stocks be good for welfare? Positive spillovers vs. equity market losses," Working Papers, Imperial College, London, Imperial College Business School 12192, Imperial College, London, Imperial College Business School.
  3. Elias Albagli & Christian Hellwig & Aleh Tsyvinski, 2011. "Information Aggregation, Investment, and Managerial Incentives," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1816, Cowles Foundation for Research in Economics, Yale University.
  4. Pesaran, M.H., 2010. "Predictability of Asset Returns and the Efficient Market Hypothesis," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 1033, Faculty of Economics, University of Cambridge.
  5. Kaizoji, Taisei (kaizoji@icu.ac.jp), 2010. "A Behavioral Model of Bubbles and Crashes," MPRA Paper 20352, University Library of Munich, Germany.
  6. Jess Benhabib & Pengfei Wang, 2014. "Private Information and Sunspots in Sequential Asset Markets," NBER Working Papers 20044, National Bureau of Economic Research, Inc.
  7. Tille, Cédric & van Wincoop, Eric, 2014. "Solving DSGE portfolio choice models with dispersed private information," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 40(C), pages 1-24.

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