A Rational Theory of "Irrational Exuberance"

The arrival of new, unfamiliar, investment opportunities - e.g., internet commerce, emerging markets, novel financial instruments - is often associated with large, "exuberant," movements in asset prices and real investment. While irrational explanations of these phenomena abound, in this paper we show that the dispersion of information that is likely to surround these new, unfamiliar investment opportunities may help explain these phenomena within an otherwise canonical, fully rational, neoclassical model of the interaction of financial markets and the real economy. On the positive front, we identify a mechanism that amplifies the response of the economy to noise (correlated, but rational, errors in assessments of the fundamentals), while at the same time formalizing the idea that "inflated prices" and "exuberant investment" may feed one another during these episodes. This mechanism rest on the property that, when information is dispersed and only then, financial markets look at aggregate investment as a signal of the underlying fundamentals. On the normative front, we document that this amplification is a symptom of constrained inefficiency: there exist policy interventions that can improve welfare without requiring the government either to have superior information than the market or to centralize the information that is dispersed in the economy.