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On the Inception of Rational Bubbles in Stock Prices

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  • Behzad T. Diba
  • Herschel I. Grossman

Abstract

This paper analyzes the theoretical possibility of rational bubbles in stock prices in a model in which stockholders have infinite planning horizons and in which free disposal of equity rules out the existence of negative rational bubbles. The analysis shows that in this framework if a positive rational bubble exists, then it started on the first date of trading of the stock. Thus, the existence of a rational bubble at any date would imply that the stock has been overvalued relative to market fundamentals since the first date of trading and that prior to the first date of trading potential stockholders who anticipated the initial pricing of the stock expected that the stock would be overvalued relative to market fundamentals. The analysis also shows that any rational bubble will eventually burst and will not restart. Thus, even if a positive rational bubble exists, stockholders know that after a random, but almost surely finite, date the stock price will conform to market fundamentals forever.

Suggested Citation

  • Behzad T. Diba & Herschel I. Grossman, 1986. "On the Inception of Rational Bubbles in Stock Prices," NBER Working Papers 1990, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1990
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    References listed on IDEAS

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    1. Michael Mussa, 1984. "Rational Expectations Models with a Continuum of Convergent Solutions," NBER Technical Working Papers 0041, National Bureau of Economic Research, Inc.
    2. Diba, Behzad T. & Grossman, Herschel I., 1988. "Rational inflationary bubbles," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 35-46, January.
    3. 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 675-687, August.
    4. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
    5. 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.
    6. Shiller, Robert J., 1978. "Rational expectations and the dynamic structure of macroeconomic models : A critical review," Journal of Monetary Economics, Elsevier, vol. 4(1), pages 1-44, January.
    7. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-1181, September.
    8. Kenneth D. West, 1987. "A Specification Test for Speculative Bubbles," The Quarterly Journal of Economics, Oxford University Press, vol. 102(3), pages 553-580.
    9. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    10. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
    11. 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 745-770, August.
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    Cited by:

    1. Kanas, Angelos, 2005. "Nonlinearity in the stock price-dividend relation," Journal of International Money and Finance, Elsevier, vol. 24(4), pages 583-606, June.

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