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The Impossibility of Rational Bubbles

  • Behzad T. Diba
  • Herschel I. Grossman

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.

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File URL: http://www.nber.org/papers/w1615.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1615.

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Date of creation: May 1985
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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.
Handle: RePEc:nbr:nberwo:1615
Note: ME EFG
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  1. 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.
  2. Evans, George & Honkapohja, Seppo, 1986. "A Complete Characterization of ARMA Solutions to Linear Rational Expectations Models," Review of Economic Studies, Wiley Blackwell, vol. 53(2), pages 227-39, April.
  3. 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.
  4. Michael Mussa, 1984. "Rational Expectations Models with a Continuum of Convergent Solutions," NBER Technical Working Papers 0041, National Bureau of Economic Research, Inc.
  5. Kingston, Geoffrey H., 1982. "The semi-log portfolio balance schedule is tenuous," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 389-399.
  6. Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
  7. 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.
  8. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
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