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Avoiding the Pitfalls: Can Regime-Switching Tests Detect Bubbles?

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  • Simon van Norden

    (Bank of Canada, International Department)

  • Robert Vigfusson

Abstract

Work on testing for bubbles has caused much debate, much of which has focused on methodology. Monte Carlo simulations reported in Evans (1991) showed that standard tests for unit roots and cointegration frequently reject the presence of bubbles even when such bubbles are present by construction. Evans referred to this problem as the pitfall of testing for bubbles. Since Evans' note, new tests for rational speculative bubbles that rely on regime switching have been proposed. van Norden and Schaller (1993) and van Norden (1996) use a switching regression to look for a time- varying relationship between returns and deviations from an approximate fundamental price. Hall and Sola (1993) and Funke, Hall and Sola (1994) test whether asset prices seem to switch between explosive growth and stationary behaviour. Our paper does Monte Carlo experiments using Evan's data generating process to gauge the performance of these two kinds of regime-switching tests. These rely heavily on new fast robust programs developed at the Bank of Canada for the estimation of switching regression models, which make Monte Carlo studies of such estimators practical. We find that for some (but not all) parameter values, regime-switching tests have significant amount of power to detect periodically collapsing bubbles. We also compare and contrast the performance of the two different regime-switching tests.

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Paper provided by EconWPA in its series Meeting papers with number 9603001.

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Date of creation: 08 Mar 1996
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Handle: RePEc:wpa:wuwpme:9603001

Note: Paper to be presented at the SNDE meeting in Boston March 16th. Text and Graphs in separate Postscript files. Both files compressed in a single Info-zip archive, then uuencoded.
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  1. Charemza, Wojciech W. & Deadman, Derek F., 1995. "Speculative bubbles with stochastic explosive roots: The failure of unit root testing," Journal of Empirical Finance, Elsevier, vol. 2(2), pages 153-163, June.
  2. Philippe Weil, 1989. "On The Possibility of Price Decreasing Bubbles," NBER Working Papers 2821, National Bureau of Economic Research, Inc.
  3. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  4. LeRoy, Stephen F, 1989. "Efficient Capital Markets and Martingales," Journal of Economic Literature, American Economic Association, vol. 27(4), pages 1583-1621, December.
  5. Simon van Norden, 1995. "Regime Switching as a Test for Exchange Rate Bubbles," Econometrics 9502001, EconWPA, revised 09 Aug 1995.
  6. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
  7. Obstfeld, Maurice & Rogoff, Kenneth, 1986. "Ruling out divergent speculative bubbles," Journal of Monetary Economics, Elsevier, vol. 17(3), pages 349-362, May.
  8. Simon van Norden & Robert Vigfusson, 1996. "Regime-Switching Models: A Guide to the Bank of Canada Gauss Procedures," Econometrics 9603004, EconWPA.
  9. Obstfeld, Maurice & Rogoff, Kenneth, 1983. "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 675-87, August.
  10. Bulow, Jeremy I & Klemperer, Paul, 1991. "Rational Frenzies and Crashes," CEPR Discussion Papers 593, C.E.P.R. Discussion Papers.
  11. Gilles, Christian & LeRoy, Stephen F, 1992. "Bubbles and Charges," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 33(2), pages 323-39, May.
  12. Franklin Allen & Gary B. Gorton, . "Rational Finite Bubbles," Rodney L. White Center for Financial Research Working Papers 41-88, Wharton School Rodney L. White Center for Financial Research.
  13. Van Norden, S. & Schaller, H., 1996. "Speculative Behaviour, Regime-Switching and Stock Market Crashes," Working Papers 96-13, Bank of Canada.
  14. Kenneth D. West, 1986. "A Specification Test for Speculative Bubbles," NBER Working Papers 2067, National Bureau of Economic Research, Inc.
  15. Hamilton, James D. & Whiteman, Charles H., 1985. "The observable implications of self-fulfilling expectations," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 353-373, November.
  16. Diba, Behzad T & Grossman, Herschel I, 1987. "On the Inception of Rational Bubbles," The Quarterly Journal of Economics, MIT Press, vol. 102(3), pages 697-700, August.
  17. Flood, Robert P & Hodrick, Robert J, 1990. "On Testing for Speculative Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 85-101, Spring.
  18. Francis X. Diebold & Joon-Haeng Lee & Gretchen C. Weinbach, 1993. "Regime switching with time-varying transition probabilities," Working Papers 93-12, Federal Reserve Bank of Philadelphia.
  19. repec:fth:calaec:13-89 is not listed on IDEAS
  20. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
  21. Funke, Michael & Hall, Stephen & Sola, Martin, 1994. "Rational bubbles during Poland's hyperinflation: Implications and empirical evidence," European Economic Review, Elsevier, vol. 38(6), pages 1257-1276, June.
  22. Froot, Kenneth A & Obstfeld, Maurice, 1991. "Intrinsic Bubbles: The Case of Stock Prices," American Economic Review, American Economic Association, vol. 81(5), pages 1189-214, December.
  23. Bhargava, Alok, 1986. "On the Theory of Testing for Unit Roots in Observed Time Series," Review of Economic Studies, Wiley Blackwell, vol. 53(3), pages 369-84, July.
  24. van Norden, Simon & Schaller, Huntley, 1993. "The Predictability of Stock Market Regime: Evidence from the Toronto Stock Exchange," The Review of Economics and Statistics, MIT Press, vol. 75(3), pages 505-10, August.
  25. Diba, Behzad T & Grossman, Herschel I, 1988. "Explosive Rational Bubbles in Stock Prices?," American Economic Review, American Economic Association, vol. 78(3), pages 520-30, June.
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Cited by:
  1. Nael Al-Anaswah & Bernd Wilfling, 2009. "Identification of speculative bubbles using state-space models with Markov-switching," CQE Working Papers 0309, Center for Quantitative Economics (CQE), University of Muenster.
  2. Maurice J. Roche & Kieran McQuinn, 2000. "Speculation in agricultural land," Economics, Finance and Accounting Department Working Paper Series n1010700, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  3. Mc Quinn, Kieran, 2004. "A Model of the Irish Housing Sector," Research Technical Papers 1/RT/04, Central Bank of Ireland.
  4. Maurice J. Roche, 1999. "Irish House Prices - Will the Roof Cave In?," The Economic and Social Review, Economic and Social Studies, vol. 30(4), pages 343-362.
  5. Kim, Bong Han & Min, Hong-Ghi, 2011. "Household lending, interest rates and housing price bubbles in Korea: Regime switching model and Kalman filter approach," Economic Modelling, Elsevier, vol. 28(3), pages 1415-1423, May.
  6. Roche, Maurice J., 2001. "The rise in house prices in Dublin: bubble, fad or just fundamentals," Economic Modelling, Elsevier, vol. 18(2), pages 281-295, April.
  7. Taipalus, Katja, 2012. "Detecting asset price bubbles with time-series methods," Scientific Monographs E:47/2012, Bank of Finland.

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