Noisy Rational Bubbles

Abstract

This paper develops a theory of asset price dynamics during extreme market episodes. In the model, noise trading breaks the winner's curse and leads to systematic overpricing. Over time, returns from resale opportunities diminish as learning proceeds, and asset prices tend to fall toward the fundamentals. Importantly, however, investors also update their expectations regarding the average precision of new information. This mechanism works to drive prices farther away from the intrinsic value. Finally, the model also allows for endogenous investor inflows that amplify price movements. The model can produce various price episodes.

Keywords: Bubble-like price dynamics, Uncertainty, Investor flows, Noisy rational expectations equilibrium

JEL Classification: D82, G12, G14