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18 Feb 2019Working Paper Summaries

Diagnostic Bubbles

by Pedro Bordalo, Nicola Gennaioli, Spencer Yongwook Kwon, and Andrei Shleifer

The financial crisis of 2007-2008 revived academic interest in price bubbles but many conceptual questions remain open. This paper generates insights into the structure of asset price bubbles by modeling beliefs from fundamental psychological assumptions, and combining this with standard neoclassical mechanisms, such as learning from prices and speculation.

Author Abstract

We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.