On the power and weakness of rational expectations: Logical fallacies, periodic bubbles and business cycles

Eduard Gracia

No 2012-27, Economics Discussion Papers from Kiel Institute for the World Economy

Abstract: A popular interpretation of the Rational Expectations/Efficient Markets hypothesis states that, if the hypothesis holds, then market valuations must follow a random walk. This postulate has frequently been criticized on the basis of empirical evidence. Yet the assertion itself incurs what we could call 'fallacy of probability diffusion symmetry': although market efficiency does indeed imply that the mean (i.e. expected) path must be a random walk, if the probability diffusion process is asymmetric then the observed path will most closely resemble not the mean but the median, which does not necessarily follow a random walk. To illustrate the implications, this paper develops an efficient markets model where the median path of Tobin's q ratio displays regular cycles of bubbles and crashes reflecting an agency problem between investors and producers. The model is tested against US market data, with results suggesting that such a regular cycle does indeed exist and is statistically significant. The aggregate production function in Gracia (Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function, 2011) is then put forward to show how financial fluctuations can drive the business cycle by periodically impacting aggregate productivity and, as a consequence, GDP growth.

Keywords: Rational Expectations; efficient markets; financial bubbles; stock markets; booms and crashes; Tobin's q; business cycles; economic rents (search for similar items in EconPapers)
JEL-codes: E22 E23 E32 G12 G14 (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-fdg and nep-mac
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