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Beauty Contests and Irrational Exuberance: A Neoclassical Approach

  • George-Marios Angeletos
  • Guido Lorenzoni
  • Alessandro Pavan

The arrival of new, unfamiliar, investment opportunities is often associated with "exuberant" movements in asset prices and real economic activity. During these episodes of high uncertainty, financial markets look at the real sector for signals about the profitability of the new investment opportunities, and vice versa. In this paper, we study how such information spillovers impact the incentives that agents face when making their real economic decisions. On the positive front, we find that the sensitivity of equilibrium outcomes to noise and to higher-order uncertainty is amplified, exacerbating the disconnect from fundamentals. On the normative front, we find that these effects are symptoms of constrained inefficiency; we then investigate policies that can improve welfare in our model without any informational advantage on the government's part. At the heart of these results is a distortion that induces a conventional neoclassical economy to behave as a Keynesian "beauty contest" and to exhibit fluctuations that may look like "irrational exuberance" to an outside observer.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15883.

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Date of creation: Apr 2010
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Handle: RePEc:nbr:nberwo:15883
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  19. George-Marios Angeletos & Alessandro Pavan, 2007. "Efficient Use of Information and Social Value of Information," Econometrica, Econometric Society, vol. 75(4), pages 1103-1142, 07.
  20. Amador, Manuel & Weill, Pierre-Olivier, 2006. "Learning from Private and Public Observation of Other's Actions," MPRA Paper 109, University Library of Munich, Germany.
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