Noisy Rational Bubbles
46 Pages Posted: 22 Sep 2015 Last revised: 31 Mar 2016
Date Written: March 24, 2016
This paper develops a theory of asset price dynamics during bubble-like episodes. In the model, noise trading breaks the winner's curse and leads to overpricing. Over time, investors gradually learn and asset prices tend to fall toward the fundamentals. Importantly, however, investors also update their expectation about the average precision of new information. This mechanism works to drive prices farther away from the intrinsic value. Finally, the model also allows for gradual investor inflows greatly amplifying predicted price movements. Numerical simulations show the model can produce various bubble-like events.
Keywords: Bubbles, Price dynamics, Uncertainty, Investor flows, Noisy rational expectations equilibrium
JEL Classification: D82, G12, G14
Suggested Citation: Suggested Citation