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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 identify policies that can improve welfare without requiring the government to have any informational advantage vis-a-vis the market. 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 Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1502.

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Date of creation: 05 Mar 2010
Date of revision:
Handle: RePEc:nwu:cmsems:1502
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  1. Alessandro Pavan & George-Marios Angeletos, 2008. "Policy with Dispersed Information," 2008 Meeting Papers 1103, Society for Economic Dynamics.
  2. Bartosz Mackowiak & Mirko Wiederholt, 2004. "Optimal Sticky Prices under Rational Inattention," SFB 649 Discussion Papers SFB649DP2005-040, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany, revised Jul 2005.
  3. repec:oup:restud:v:79:y:2012:i:2:p:539-580 is not listed on IDEAS
  4. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2007. "Wall Street and Silicon Valley: A Delicate Interaction," NBER Working Papers 13475, National Bureau of Economic Research, Inc.
  5. Laura Veldkamp & Christian Hellwig, 2006. "Knowing What Others Know: Coordination Motives in Information Acquisition," Working Papers 06-14, New York University, Leonard N. Stern School of Business, Department of Economics.
  6. James Dow & Gary Gorton, . "Stock Market Efficiency and Economic Efficiency: Is There a Connection?," Rodney L. White Center for Financial Research Working Papers 16-95, Wharton School Rodney L. White Center for Financial Research.
  7. Laura Veldkamp, 2004. "Media Frenzies in Markets for Financial Information," Econometric Society 2004 North American Winter Meetings 4, Econometric Society.
  8. Itay Goldstein & Emre Ozdenoren & Kathy Yuan, 2011. "Trading Frenzies and their Impact on Real Investment," FMG Discussion Papers dp670, Financial Markets Group.
  9. repec:oup:restud:v:77:y:2010:i:1:p:305-338 is not listed on IDEAS
  10. David P. Myatt & Chris Wallace, 2009. "Endogenous Information Acquisition in Coordination Games," Economics Series Working Papers 445, University of Oxford, Department of Economics.
  11. 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.
  12. Vives, X., 1993. "Learning from Others," UFAE and IAE Working Papers 206.93, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  13. Giovanni Cespa & Xavier Vives, 2008. "Dynamic Trading and Asset Prices: Keynes vs. Hayek," CSEF Working Papers 191, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  14. George-Marios Angeletos & Jennifer La'O, 2010. "Noisy Business Cycles," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 319-378 National Bureau of Economic Research, Inc.
  15. Manuel Amador & Pierre Olivier Weill, 2008. "Learning from Prices: Public Communication and Welfare," 2008 Meeting Papers 390, Society for Economic Dynamics.
  16. Christian Hellwig, . "Monetary Business Cycle Models: Imperfect Information (Review Article, March 2006)," UCLA Economics Online Papers 377, UCLA Department of Economics.
  17. repec:oup:restud:v:75:y:2008:i:1:p:133-164 is not listed on IDEAS
  18. Simon Gilchrist & Charles P. Himmelberg & Gur Huberman, 2004. "Do stock price bubbles influence corporate investment?," Staff Reports 177, Federal Reserve Bank of New York.
  19. Guido Lorenzoni, 2010. "Optimal Monetary Policy with Uncertain Fundamentals and Dispersed Information ," Review of Economic Studies, Oxford University Press, vol. 77(1), pages 305-338.
  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.
  21. Itay Goldstein & Alexander Guembel & James Dow, 2008. "Incentives for Information Production in Markets where Prices Affect Real Investment," 2008 Meeting Papers 270, Society for Economic Dynamics.
  22. Xavier Vives, 2007. "Information and Learning in Markets," Levine's Bibliography 122247000000001520, UCLA Department of Economics.
  23. Franck Portier & Aude Pommeret & Olivier Loisel, 2008. "Monetary policy and herd behavior in new-tech investment," 2008 Meeting Papers 444, Society for Economic Dynamics.
  24. Dupor, Bill, 2005. "Stabilizing non-fundamental asset price movements under discretion and limited information," Journal of Monetary Economics, Elsevier, vol. 52(4), pages 727-747, May.
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