The Impossibility of Rational Bubbles
A rational bubble would involve a self-confirming belief that an asset price depends on information that includes variables or parameters that are not part of market fundamentals. The existing literature shows that, if market fundamentals are economically interesting, i.e., forward looking, any rational bubbles would be either explosive or implosive. Further arguments based on the existing literature show that utility maximizing behavior implies finite bounds on asset prices and, accordingly, precludes both explosive and implosive rational price expectations, except for the possible case of an implosion in the value of fiat money. These arguments rule out both positive and negative rational bubbles, except for the poissibility of rational inflationary bubbles.This paper extends the theoretical analysis of rational bubbles in two ways. First, it shows that, although a supply response of the current asset stock to the current asset price dampens fluctuations in market fundamentals, such a response would cause a rational bubble to explode or to implode even faster.Thus, the explosiveness or implosiveness of rational bubbles isnot an artifact of assuming that the asset stock evolves autonomously. Second, and more importantly, the present analysis considers the inception of rational bubbles and shows that, for anegative rational bubble -- such as a rational inflationary bubble -- to get started, a positive rational bubble also would have to have positive probability. Specifically, the expected initial absolute value of a potential negative rational bubble cannot exceed the expected, initial value of a potential positive rational bubble.This result dramatically expands the theoretical basis for precluding rational bubbles. Specifically, because utility maximization directly rules out rational deflationary bubbles, the inception of a rational inflationary bubbles is also precluded.
|Date of creation:||May 1985|
|Date of revision:|
|Publication status:||published as Diba, Behzad T. and Herschel I. Grossman. "On the Inception of Rational Bubbles," Quarterly Journal of Economics, Vol. 102, No. 409, August 1987.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Flood, Robert P & Garber, Peter M, 1980. "Market Fundamentals versus Price-Level Bubbles: The First Tests," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 745-70, August.
- Michael Mussa, 1984. "Rational Expectations Models with a Continuum of Convergent Solutions," NBER Technical Working Papers 0041, National Bureau of Economic Research, Inc.
- Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
- Obstfeld, Maurice & Rogoff, Kenneth S., 1983.
"Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?,"
12491027, Harvard University Department of Economics.
- Obstfeld, Maurice & Rogoff, Kenneth, 1983. "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 675-87, August.
- Maurice Obstfeld & Kenneth S. Rogoff, 1981. "Speculative hyperinflations in a maximizing models: can we rule them out?," International Finance Discussion Papers 195, Board of Governors of the Federal Reserve System (U.S.).
- Maurice Obstfeld & Kenneth Rogoff, 1982. "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?," NBER Working Papers 0855, National Bureau of Economic Research, Inc.
- Gray, Jo Anna, 1984.
"Dynamic Instability in Rational Expectations Models: An Attempt to Clarify,"
International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 93-122, February.
- Jo Anna Gray, 1982. "Dynamic instability in rational expectations models: an attempt to clarify," International Finance Discussion Papers 197, Board of Governors of the Federal Reserve System (U.S.).
- Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
- George Evans & Seppo Honkapohja, 1986. "A Complete Characterization of ARMA Solutions to Linear Rational Expectations Models," Review of Economic Studies, Oxford University Press, vol. 53(2), pages 227-239.
- Kingston, Geoffrey H., 1982. "The semi-log portfolio balance schedule is tenuous," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 389-399.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:1615. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.