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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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Bibliographic Info

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. Manuel Amador & Pierre-Olivier Weill, 2008. "Learning from Prices: Public Communication and Welfare," NBER Working Papers 14255, National Bureau of Economic Research, Inc.
  2. Davidson, Malcolm & Gorton, Gary B, 1995. "Stock Market Efficiency and Economic Efficiency: Is There a Connection?," CEPR Discussion Papers 1261, C.E.P.R. Discussion Papers.
  3. Goldstein, Itay & Ozdenoren, Emre & Yuan, Kathy, 2013. "Trading frenzies and their impact on real investment," Journal of Financial Economics, Elsevier, vol. 109(2), pages 566-582.
  4. David P. Myatt & Chris Wallace, 2009. "Endogenous Information Acquisition in Coordination Games," Economics Series Working Papers 445, University of Oxford, Department of Economics.
  5. Gilchrist, Simon & Himmelberg, Charles P. & Huberman, Gur, 2005. "Do stock price bubbles influence corporate investment?," Journal of Monetary Economics, Elsevier, vol. 52(4), pages 805-827, May.
  6. Laura Veldkamp, 2003. "Media Frenzies in Markets for Financial Information," Working Papers 03-20, New York University, Leonard N. Stern School of Business, Department of Economics.
  7. Amador, Manuel & Weill, Pierre-Olivier, 2006. "Learning from Private and Public Observation of Other's Actions," MPRA Paper 109, University Library of Munich, Germany.
  8. Mirko Wiederholt & Bartosz Mackowiak, 2005. "Optimal Sticky Prices under Rational Inattention," 2005 Meeting Papers 369, Society for Economic Dynamics.
  9. 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.
  10. Christian Hellwig & Laura Veldkamp, 2006. "Knowing what others Know: Coordination motives in information acquisition," 2006 Meeting Papers 361, Society for Economic Dynamics.
  11. Dupor, Bill, 2005. "Stabilizing non-fundamental asset price movements under discretion and limited information," Journal of Monetary Economics, Elsevier, vol. 52(4), pages 727-747, May.
  12. Christian Hellwig, . "Monetary Business Cycle Models: Imperfect Information (Review Article, March 2006)," UCLA Economics Online Papers 377, UCLA Department of Economics.
  13. George-Marios Angeletos & Alessandro Pavan, 2007. "Efficient Use of Information and Social Value of Information," Econometrica, Econometric Society, vol. 75(4), pages 1103-1142, 07.
  14. George-Marios Angeletos & Alessandro Pavan, 2008. "Policy with Dispersed Information," Carlo Alberto Notebooks 86, Collegio Carlo Alberto.
  15. Franck Portier & Aude Pommeret & Olivier Loisel, 2008. "Monetary policy and herd behavior in new-tech investment," 2008 Meeting Papers 444, Society for Economic Dynamics.
  16. 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.
  17. repec:bla:restud:v:77:y:2010:i:1:p:305-338 is not listed on IDEAS
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Cited by:
  1. Tinn, K & Vourvachaki, E, 2013. "Can overpricing of technology stocks be good for welfare? Positive spillovers vs. equity market losses," Working Papers 12192, Imperial College, London, Imperial College Business School.
  2. Goldstein, Itay & Ozdenoren, Emre & Yuan, Kathy, 2010. "Trading Frenzies and Their Impact on Real Investment," CEPR Discussion Papers 7652, C.E.P.R. Discussion Papers.
  3. Jess Benhabib & Pengfei Wang, 2014. "Private Information and Sunspots in Sequential Asset Markets," NBER Working Papers 20044, National Bureau of Economic Research, Inc.
  4. Kaizoji, Taisei (kaizoji@icu.ac.jp), 2010. "A behavioral model of bubbles and crashes," MPRA Paper 35655, University Library of Munich, Germany.
  5. Tille, Cédric & van Wincoop, Eric, 2014. "Solving DSGE portfolio choice models with dispersed private information," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 1-24.
  6. Pesaran, M.H., 2010. "Predictability of Asset Returns and the Efficient Market Hypothesis," Cambridge Working Papers in Economics 1033, Faculty of Economics, University of Cambridge.
  7. Elias Albagli & Christian Hellwig & Aleh Tsyvinski, 2011. "Information Aggregation, Investment, and Managerial Incentives," Levine's Working Paper Archive 786969000000000197, David K. Levine.

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