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Testable Implications of Indeterminacies in Models with Rational Expectations

  • Robert P. Flood
  • Robert J. Hodrick

The possibility that movements in market prices of assets or goods may be caused by self-fulfilling prophecies, called bubbles or sunspots, has long intrigued market observers. If bubbles or sunspots exist, market prices differ from their fundamental values, and markets do not necessarily allocate resources to their best possible uses. Some might argue then that public policies would be needed to alleviate such problems. This paper surveys the current state of the empirically-oriented literature concerning rational dynamic indeterminacies by which we mean a situation of self-fulfilling prophecy within a rational expectations model. The empirical work in this area concentrates primarily on indeterminacies in price levels, exchange rates and equity prices. We first examine a particular type of explosive indeterminacy, usually called a rational bubble, in a familiar model of equity pricing. We then consider empirical work relating to price level and exchange rate indeterminacies, before examining empirical studies of indeterminacies in stock prices. Finally, we take up some interpretive issues. We find that existing bubbles tests do not establish that rational bubbles exist in asset prices.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2903.

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Date of creation: Mar 1989
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Publication status: published as The Journal of Economic Perspectives, vol.4, no.1, Winter 1990
Handle: RePEc:nbr:nberwo:2903
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  9. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
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  15. Robert J. Shiller, 1975. "Rational Expectations and the Dynamic Structure of Macroeconomic Models:A Critical Review," NBER Working Papers 0093, National Bureau of Economic Research, Inc.
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  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. Brock, William A, 1974. "Money and Growth: The Case of Long Run Perfect Foresight," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 15(3), pages 750-77, October.
  20. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  21. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," NBER Working Papers 1885, National Bureau of Economic Research, Inc.
  22. Hamilton, James D. & Whiteman, Charles H., 1985. "The observable implications of self-fulfilling expectations," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 353-373, November.
  23. Brock, William A., 1980. "Asset Prices in a Production Economy," Working Papers 275, California Institute of Technology, Division of the Humanities and Social Sciences.
  24. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  25. Jeffrey A. Frankel, 1985. "The Dazzling Dollar," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 199-217.
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  27. James M. Poterba & Lawrence H. Summers, 1987. "Mean Reversion in Stock Prices: Evidence and Implications," NBER Working Papers 2343, National Bureau of Economic Research, Inc.
  28. 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.
  29. Joe Mattey and Richard Meese., 1986. "Empirical Assessment of Present Value Relations," Research Program in Finance Working Papers 162, University of California at Berkeley.
  30. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  31. Robert P. Flood & Robert J. Hodrick & Paul Kaplan, 1986. "An Evaluation of Recent Evidence on Stock Market Bubbles," NBER Working Papers 1971, National Bureau of Economic Research, Inc.
  32. Woodford, Michael, 1986. "Stationary sunspot equilibria in a finance constrained economy," Journal of Economic Theory, Elsevier, vol. 40(1), pages 128-137, October.
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  35. Burmeister, Edwin & Wall, Kent D., 1982. "Kalman filtering estimation of unobserved rational expectations with an application to the German hyperinflation," Journal of Econometrics, Elsevier, vol. 20(2), pages 255-284, November.
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  39. Kleidon, Allan W, 1986. "Variance Bounds Tests and Stock Price Valuation Models," Journal of Political Economy, University of Chicago Press, vol. 94(5), pages 953-1001, October.
  40. Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
  41. Lars Peter Hansen & Thomas J. Sargent, 1979. "Formulating and estimating dynamic linear rational expectations models," Working Papers 127, Federal Reserve Bank of Minneapolis.
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