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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 identify policies that can improve welfare without requiring the government to have any informational advantage vis-a-vis the market. 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 Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1502.

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Date of creation: 05 Mar 2010
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Handle: RePEc:nwu:cmsems:1502

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Keywords: Incomplete information; beauty contests; exuberance; informational frictions; endogenous complementarities JEL Classification Numbers: C72; D62; D82;

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References

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  1. 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.
  2. 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.
  3. Mirko Wiederholt & Bartosz Mackowiak, 2005. "Optimal Sticky Prices under Rational Inattention," 2005 Meeting Papers 369, Society for Economic Dynamics.
  4. James Dow & Gary Gorton, 1995. "Stock Market Efficiency and Economic Efficiency: Is There a Connection?," NBER Working Papers 5233, 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. Laura L. Veldkamp, 2006. "Media Frenzies in Markets for Financial Information," American Economic Review, American Economic Association, vol. 96(3), pages 577-601, June.
  7. George-Marios Angeletos & Alessandro Pavan, 2007. "Policy with Dispersed Information," NBER Working Papers 13590, National Bureau of Economic Research, Inc.
  8. 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.
  9. Christian Hellwig, . "Monetary Business Cycle Models: Imperfect Information (Review Article, March 2006)," UCLA Economics Online Papers 377, UCLA Department of Economics.
  10. Manuel Amador & Pierre-Olivier Weill, 2010. "Learning from Prices: Public Communication and Welfare," Journal of Political Economy, University of Chicago Press, vol. 118(5), pages 866 - 907.
  11. Franck Portier & Aude Pommeret & Olivier Loisel, 2008. "Monetary policy and herd behavior in new-tech investment," 2008 Meeting Papers 444, Society for Economic Dynamics.
  12. 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.
  13. Christian Hellwig & Laura Veldkamp, 2006. "Knowing what others Know: Coordination motives in information acquisition," 2006 Meeting Papers 361, Society for Economic Dynamics.
  14. 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.
  15. Gur Huberman & Simon Gilchrist & Charles Himmelberg, 2004. "Do Stock Price Bubbles Influence Corporate Investment?," 2004 Meeting Papers 147, Society for Economic Dynamics.
  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. David P. Myatt & Chris Wallace, 2009. "Endogenous Information Acquisition in Coordination Games," Economics Series Working Papers 445, University of Oxford, Department of Economics.
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Cited by:
  1. 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.
  2. M. Hashem Pesaran, 2010. "Predictability of Asset Returns and the Efficient Market Hypothesis," CESifo Working Paper Series 3116, CESifo Group Munich.
  3. Albagli, Elias & Hellwig, Christian & Tsyvinski, Aleh, 2011. "Information Aggregation, Investment, and Managerial Incentives," CEPR Discussion Papers 8539, C.E.P.R. Discussion Papers.
  4. 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.
  5. 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.
  6. Kaizoji, Taisei (kaizoji@icu.ac.jp), 2010. "A behavioral model of bubbles and crashes," MPRA Paper 35655, University Library of Munich, Germany.
  7. Jess Benhabib & Pengfei Wang, 2014. "Private Information and Sunspots in Sequential Asset Markets," NBER Working Papers 20044, National Bureau of Economic Research, Inc.

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