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Predicting the unpredictable: Forecastable bubbles and business cycles under rational expectations

  • Gracia, Eduard
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    A popular interpretation of the Rational Expectations/Efficient Markets hypothesis states that, if it holds, market valuations must follow a random walk; hence, the hypothesis is frequently criticized on the basis of empirical evidence against such a prediction. Yet this reasoning incurs what we could call the 'fallacy of probability diffusion symmetry': although market efficiency does indeed imply that the mean (i.e. 'expected') path must rule out any cyclical or otherwise arbitrage-enabling pattern, if the probability diffusion process is asymmetric the observed path will most closely resemble not the mean but the median, which is not subject to this condition. In this context, this paper develops an efficient markets model where the median path of Tobin's q ratio displays regular, periodic cycles of bubbles and crashes reflecting an agency problem between investors and producers. The model is tested against U.S. market data, and its results suggest that such a regular cycle does indeed exist and is statistically significant. The aggregate production model in Gracia (Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function, 2011) is then put forward to show how financial fluctuations can drive the business cycle by periodically impacting aggregate productivity and, as a consequence, GDP growth.

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    Article provided by Kiel Institute for the World Economy in its journal Economics: The Open-Access, Open-Assessment E-Journal.

    Volume (Year): 6 (2012)
    Issue (Month): ()
    Pages: 1-43

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    Handle: RePEc:zbw:ifweej:201241
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    1. Kim Jong-Il & Lau Lawrence J., 1994. "The Sources of Economic Growth of the East Asian Newly Industrialized Countries," Journal of the Japanese and International Economies, Elsevier, vol. 8(3), pages 235-271, September.
    2. John Shea, 1998. "What Do Technology Shocks Do?," NBER Working Papers 6632, National Bureau of Economic Research, Inc.
    3. Bezemer, Dirk, 2009. "No one saw this coming. Understanding financial crisis through accounting models," Research Report 09002, University of Groningen, Research Institute SOM (Systems, Organisations and Management).
    4. Ramsey, J.B. & Rothman, P., 1993. "Time Irreversibility and Business Cycle Asymmetry," Working Papers 93-39, C.V. Starr Center for Applied Economics, New York University.
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