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Modeling speculative bubbles with diverse investor expectations

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  • Phillips, Peter C.B.

Abstract

We construct a model of asset market exuberance, collapse and recovery using subjective investor-based rational expectations about the impact of fundamentals on the market price. Investors are assumed to have heterogeneous market sentiments, allowing them to be exuberant, cautious, or fundamentalist via boundary conditions that describe their respective views of the market impact of the same economic fundamentals. Equilibrium solution paths of the model take varying forms, depending on the parameter settings that reflect the importance of each type of market participant. This rational expectations model of asset pricing is shown to be consistent with a simple explosive continuous time autoregression when exuberant sentiment dominates the market. The model explains asset price bubbles, including expansion and subsequent collapse, together with long-term recovery. Extensions of the model allow for contagion effects in which market sentiments are transmitted from a primary market to a secondary market, reproducing speculative behavior and corrections in the secondary market. Some of the implications of the model for empirical work are explored.

Suggested Citation

  • Phillips, Peter C.B., 2016. "Modeling speculative bubbles with diverse investor expectations," Research in Economics, Elsevier, vol. 70(3), pages 375-387.
  • Handle: RePEc:eee:reecon:v:70:y:2016:i:3:p:375-387
    DOI: 10.1016/j.rie.2016.01.002
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    References listed on IDEAS

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    1. Peter C. B. Phillips & Shuping Shi & Jun Yu, 2015. "Testing For Multiple Bubbles: Historical Episodes Of Exuberance And Collapse In The S&P 500," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 56, pages 1043-1078, November.
    2. C. Wei Li & Hui Xue, 2009. "A Bayesian's Bubble," Journal of Finance, American Finance Association, vol. 64(6), pages 2665-2701, December.
    3. Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
    4. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
    5. Peter C. B. Phillips & Jun Yu, 2011. "Dating the timeline of financial bubbles during the subprime crisis," Quantitative Economics, Econometric Society, vol. 2(3), pages 455-491, November.
    6. Phillips, Peter C.B. & Magdalinos, Tassos, 2007. "Limit theory for moderate deviations from a unit root," Journal of Econometrics, Elsevier, vol. 136(1), pages 115-130, January.
    7. Peter C. B. Phillips & Shuping Shi & Jun Yu, 2015. "Testing For Multiple Bubbles: Limit Theory Of Realā€Time Detectors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 56, pages 1079-1134, November.
    8. Phillips, P C B, 1991. "Error Correction and Long-Run Equilibrium in Continuous Time," Econometrica, Econometric Society, vol. 59(4), pages 967-980, July.
    9. Krugman,Paul & Miller,Marcus (ed.), 1992. "Exchange Rate Targets and Currency Bands," Cambridge Books, Cambridge University Press, number 9780521435260.
    10. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
    11. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 669-682.
    12. Phillips, P C B, 1972. "The Structural Estimation of a Stochastic Differential Equation System," Econometrica, Econometric Society, vol. 40(6), pages 1021-1041, November.
    13. Peter C.B. Phillips & Shu-Ping Shi, 2014. "Financial Bubble Implosion," Cowles Foundation Discussion Papers 1967, Cowles Foundation for Research in Economics, Yale University.
    14. Paul Krugman & Marcus Miller, 1992. "Exchange Rate Targets and Currency Bands," NBER Books, National Bureau of Economic Research, Inc, number krug92-1, June.
    15. J. Michael Harrison & David M. Kreps, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, Oxford University Press, vol. 92(2), pages 323-336.
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    Cited by:

    1. Peter C. B. Phillips, 2017. "Detecting Financial Collapse and Ballooning Sovereign Risk," Cowles Foundation Discussion Papers 3010, Cowles Foundation for Research in Economics, Yale University.
    2. Peter C. B. Phillips, 2017. "Detecting Financial Collapse and Ballooning Sovereign Risk," Cowles Foundation Discussion Papers 2110, Cowles Foundation for Research in Economics, Yale University.

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