A Robust Model of Bubbles With Multidimensional Uncertainty

Authors

  • Antonio Doblas-Madrid

    1. Dept. of Economics, Michigan State University, 110 Marshall–Adams Hall, East Lansing, MI 48824, U.S.A.; doblasma@msu.edu
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    • This paper has greatly benefited from comments by Luis Araujo, Braz Camargo, John Conlon, Thomas Jeitschko, Timothy Kehoe, Andreas Park, Francisco Peñaranda, Juan Rubio-Ramírez, and Jean Tirole, as well as by a co-editor and three anonymous referees. I am also indebted to participants in various seminars and conferences for helpful comments and suggestions. All errors are my own.


Abstract

Observers often interpret boom–bust episodes in asset markets as speculative frenzies where asymmetrically informed investors buy overvalued assets hoping to sell to a greater fool before the crash. Despite its intuitive appeal, however, this notion of speculative bubbles has proven difficult to reconcile with economic theory. Existing models have been criticized on the basis that they assume irrationality, that prices are somewhat unresponsive to sales, or that they depend on fragile, knife-edge restrictions. To address these issues, I construct a rational version of Abreu and Brunnermeier (2003), where agents invest growing endowments into an asset, fueling appreciation and eventual overvaluation. Riding bubbles is optimal as long as the growth rate of the bubble and the probability of selling before the crash are high enough. This probability increases with the amount of noise in the economy, as random short-term fluctuations make it difficult for agents to infer information from prices.

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