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Bubbles and Crashes in a Behavioural Finance Model

  • De Grauwe, Paul


    (University of Leuven)

  • Grimaldi, Marianna


    (Research Department, Central Bank of Sweden)

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    We develop a simple model of the exchange rate in which agents optimize their portfolio and use different forecasting rules. They check the profitability of these rules ex post and select the more profitable one. This model produces two kinds of equilibria, a fundamental and a bubble one. In a stochastic environment the model generates a complex dynamics in which bubbles and crashes occur at unpredictable moments. We contrast these "behavioural" bubbles with "rational" bubbles.

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    Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 164.

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    Length: 44 pages
    Date of creation: 01 May 2004
    Date of revision:
    Handle: RePEc:hhs:rbnkwp:0164
    Contact details of provider: Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
    Phone: 08 - 787 00 00
    Fax: 08-21 05 31
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    1. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
    2. Lux, Thomas & Sornette, Didier, 2002. "On Rational Bubbles and Fat Tails," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 589-610, August.
    3. repec:att:wimass:9530 is not listed on IDEAS
    4. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
    5. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    6. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, vol. 96(3), pages 552-576, June.
    7. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
    8. Shang-Jin Wei & Jungshik Kim, 1999. "The Big Players in the Foreign Exchange Market: Do They Trade on Information or Noise?," CID Working Papers 5, Center for International Development at Harvard University.
    9. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
    10. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
    11. repec:cup:cbooks:9780521466004 is not listed on IDEAS
    12. Lui, Yu-Hon & Mole, David, 1998. "The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence," Journal of International Money and Finance, Elsevier, vol. 17(3), pages 535-545, June.
    13. Charles Engel & James Morley, 2000. "The Adjustment of Prices and the Adjustment of the Exchange Rate," Discussion Papers in Economics at the University of Washington 0009, Department of Economics at the University of Washington.
    14. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 304-314, June.
    15. Kenneth A. Froot & Jeffrey A. Frankel, 1986. "Interpreting Tests of Forward Discount Bias Using Survey Data on Exchange Rate Expectations," NBER Working Papers 1963, National Bureau of Economic Research, Inc.
    16. Mordecai Kurz & Maurizio Motolese, . "Endogenous Uncertainty and Market Volatility," Working Papers 99005, Stanford University, Department of Economics.
    17. Menkhoff, Lukas, 1997. "Examining the Use of Technical Currency Analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 2(4), pages 307-18, October.
    18. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    19. Evans, Martin D. & Lyons, Richard K., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance, Working Paper Series qt0dh1c16w, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
    20. repec:cup:cbooks:9780521460477 is not listed on IDEAS
    21. Carl Chiarella & Roberto Dieci & Laura Gardini, 2001. "Speculative Behaviour and Complex Asset Price Dynamics," Research Paper Series 49, Quantitative Finance Research Centre, University of Technology, Sydney.
    22. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, number 9780198296980.
    23. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
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