Diagnostic bubbles

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

Journal of Financial Economics, 2021, vol. 141, issue 3, 1060-1077

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 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, then overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a by-product of beliefs about fundamentals, lasting only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.

Keywords: Bubble; Speculation; Diagnostic expectations (search for similar items in EconPapers)
JEL-codes: G11 G12 G14 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Diagnostic Bubbles (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:141:y:2021:i:3:p:1060-1077

DOI: 10.1016/j.jfineco.2020.06.019

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