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Diagnostic Bubbles

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  • Pedro Bordalo
  • Nicola Gennaioli
  • Spencer Yongwook Kwon
  • Andrei Shleifer

Abstract

We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.

Suggested Citation

  • Pedro Bordalo & Nicola Gennaioli & Spencer Yongwook Kwon & Andrei Shleifer, 2018. "Diagnostic Bubbles," NBER Working Papers 25399, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:25399
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    Cited by:

    1. James Graham, 2022. "Boom and Bust: A Global History of Financial Bubbles," The Economic Record, The Economic Society of Australia, vol. 98(322), pages 324-326, September.

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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G4 - Financial Economics - - Behavioral Finance

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