A Bayesian's 'Bubble'

Abstract

The acceleration of U.S. productivity growth in late 1990s suggests a significant advance in technological innovations, making the perceived probability of entering a "new economy" ever increasing. Based on macroeconomic data, we identify a Bayesian investor's belief evolution when facing a possible structural break in the economy. We show that such a belief evolution plays a significant role in explaining both the stock market boom and the crash during 1998-2001. We conclude that a rational investor's uncertainty about the future of the U.S. economy provides an alternative explanation for the late 1990s' stock market "bubble".

Keywords: Bubble, total factor productivity, Bayesian update, technological innovations

JEL Classification: G12