Predator-Prey: An Alternative Model of Stock Market Bubbles and the Business Cycle (Non-Technical Version)
25 Pages Posted: 9 Dec 2004
Date Written: October 2004
For the last quarter of a century or so, the Real Business Cycle (or "RBC") model has stood as the dominant interpretation of the business cycle in mainstream economics, although throughout this long period a significant number of relevant empirical objections have been raised, both regarding its fit to "real" aggregate data and its consistency of its predictions regarding the expected behaviour of the financial markets throughout the process. All this suggests there is room to explore an alternative model. This paper proposes to base such a model on a predator-prey mechanism, along the lines of the classical Lotka-Volterra model for ecosystem dynamics, in which agency costs play the role of the predatory activity. The result is a system where "producers" (i.e., those in direct, hands-on contact with production) gradually gain control of the productive process when the times are good, and use this control to enhance their own well-being at the expense of the investors (thus increasing agency costs) until this depredation drives the system into a crisis that leads the investors to tighten their bureaucratic controls on the producers, which eventually brings the system back to the growth path. In this context, the introduction of the Efficient Markets Hypothesis in the model of course results in the resulting cycle being fully discounted from the future expected path by the rational investors but, as the market rate of return is assumed to be subject to a random walk perturbation, the growth rate that will most approximate the one in a time series of empirical observations (i.e., the one minimising the tracking error) is the median path, not the mean (whereas the market discounts the future impact of the cycle from the mean, i.e., the "expected" path, not the median) - hence, we should expect the cycle to appear on the observed time series even though market efficiency precludes it from the future expected path. Consistently with this, the resulting model also predicts that observed stock market valuations would present instances of bubbles and crashes more or less synchronised with the Business Cycle, without this implying any irrational behaviour on the part of the investors. Based on a preliminary analysis of the features of this model against well-known stylised facts, this paper suggests that it may be able to perform better against empirical validation than the Real Business Cycle model.
Note: This paper constitutes a non-technical version of a related paper available at http://ssrn.com/abstract=549741
Keywords: Business cycles, agency costs, information asymmetries, financial bubbles, predator-prey model
JEL Classification: E32
Suggested Citation: Suggested Citation