Booms and busts in asset prices

Adam, Klaus and Marcet, Albert (2011) Booms and busts in asset prices. CEP Discussion Papers (CEPDP1059). London School of Economics and Political Science. Centre for Economic Performance, London, UK.

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Abstract

We show how low-frequency boom and bust cycles in asset prices can emerge from Bayesian learning by investors. Investors rationally maximize infinite horizon utility but hold subjective priors about the asset return process that we allow to differ infinitesimally from the rational expectations prior. Bayesian updating of return beliefs then gives rise to selfreinforcing return optimism that results in an asset price boom. The boom endogenously comes to an end because return optimism causes investors to make optimistic plans about future consumption. The latter reduces the demand for assets that allow to intertemporally transfer resources. Once returns fall short of expectations, investors revise return expectations downward and set in motion a self-reinforcing price bust. In line with available survey data, the learning model predicts return optimism to comove positively with market valuation. In addition, the learning model replicates the low frequency behavior of the U.S. price dividend ratio over the period 1926-2006.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://cep.lse.ac.uk/_new/publications/discussion...
Additional Information:	© 2011 The Author(s)
Divisions:	Centre for Economic Performance
Subjects:	H Social Sciences > HC Economic History and Conditions
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D84 - Expectations; Speculations
Date Deposited:	29 Feb 2024 15:24
Last Modified:	14 Sep 2024 04:44
URI:	http://eprints.lse.ac.uk/id/eprint/121706

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