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The Theory of Rational Bubbles in Stock Prices

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  • Diba, Behzad T
  • Grossman, Herschel I

Abstract

Free disposal of equity, which directly rules out the existence of negative rational bubbles in stock pric es, also imposes theoretical restrictions on the possible existence o f positive rational bubbles. The analysis in this paper shows that a positive rational bubble can start only on the first date of trading of a stock. Thus, the existence of a rational bubble at any date woul d imply that the stock has been overvalued relative to market fundame ntals since the first date of trading, and that prior to the first da te of trading the issuer of the stock and potential stockholders who anticipated the initial pricing of the stock expected that the stock would be overvalued. Copyright 1988 by Royal Economic Society.

Suggested Citation

  • Diba, Behzad T & Grossman, Herschel I, 1988. "The Theory of Rational Bubbles in Stock Prices," Economic Journal, Royal Economic Society, vol. 98(392), pages 746-754, September.
  • Handle: RePEc:ecj:econjl:v:98:y:1988:i:392:p:746-54
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    1. Feltenstein, Andrew & Lebow, David & van Wijnbergen, Sweder, 1990. "Savings, Commodity Market Rationing, and the Real Rate of Interest in China," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(2), pages 234-252, May.
    2. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    3. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
    4. Aizenman, Joshua, 1989. "Monopolistic competition, relative prices, and output adjustment in the open economy," Journal of International Money and Finance, Elsevier, vol. 8(1), pages 5-28, March.
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