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Relative Wealth Concerns and Financial Bubbles

35 Pages Posted: 1 Nov 2006  

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Ron Kaniel

University of Rochester - Simon Business School; CEPR

Ilan Kremer

Independent

Multiple version iconThere are 3 versions of this paper

Date Written: September 2005

Abstract

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.

Suggested Citation

DeMarzo, Peter M. and Kaniel, Ron and Kremer, Ilan, Relative Wealth Concerns and Financial Bubbles (September 2005). Sixteenth Annual Utah Winter Finance Conference. Available at SSRN: https://ssrn.com/abstract=941509 or http://dx.doi.org/10.2139/ssrn.941509

Peter M. DeMarzo (Contact Author)

Stanford Graduate School of Business ( email )

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Stanford, CA 94305-5015
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650-725-7979 (Fax)

HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Ron Kaniel

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Ilan Kremer

Independent

No Address Available

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