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Knowledge, Interest Rates, and Asset Price Bubbles

Author

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  • Daniel Graydon Stephenson

    (Department of Economics, VCU School of Business)

Abstract

An outcome is said to be rationalizable if it is consistent with the assumption that agents possess common knowledge of rationality. We show that shorter investment horizons and lower interest rates produce larger larger deviations from the unique rationalizable price path in continuous-time asset markets. If investors possess common knowledge of rationality, prices converge on fundamentals as quickly as possible. Conversely, if investors possess only finite order knowledge of rational- ity, prices exhibit bubbles and crashes that deviate from the rational- izable price path. Shorter investment horizons and lower interest rates are shown to amplify bubbles and crashes.

Suggested Citation

  • Daniel Graydon Stephenson, 2023. "Knowledge, Interest Rates, and Asset Price Bubbles," Working Papers 2301, VCU School of Business, Department of Economics.
    • Handle: RePEc:vcu:wpaper:2302
    as

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    References listed on IDEAS

    as
    1. Allen F. & Morris S. & Postlewaite A., 1993. "Finite Bubbles with Short Sale Constraints and Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 61(2), pages 206-229, December.
    2. Aumann, Robert J., 1995. "Backward induction and common knowledge of rationality," Games and Economic Behavior, Elsevier, vol. 8(1), pages 6-19.
    3. John R. Conlon, 2004. "Simple Finite Horizon Bubbles Robust to Higher Order Knowledge," Econometrica, Econometric Society, vol. 72(3), pages 927-936, May.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)

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