Relative Wealth Concerns and Financial Bubbles
35 Pages Posted: 1 Nov 2006
Date Written: September 2005
We present a simple yet fully rational general equilibrium model that highlights the fact that relative wealth concerns can play a role in explaining the presence and dynamics of financial "bubbles." Because our model has a finite horizon, our explanation for the existence of bubbles is distinct from typical models of bubbles.
We consider a finite-horizon overlapping generations model and show that though agents care only about their own consumption, competition over future investment opportunities makes agents' utilities dependent on the wealth of their cohort and induces relative wealth concerns. To minimize the risk of their relative wealth, agents have an incentive to "herd" in their portfolio choice, distorting asset prices. Herding incentives and price distortions grow over time as the young become wealthier and their impact on the market increases. Though agents anticipate that a negative shock will burst the bubble and lead to a substantial loss, due to relative wealth concerns they are afraid to trade against the crowd. We show that bubbles can emerge as long as relative wealth concerns are sufficiently strong, and there is sufficient heterogeneity across agents' preferences.
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