Finite Bubbles with Short Sale Constraints and Asymmetric Information (Reprint 042)

Franklin Allen, Stephen Morris and Andrew Postlewaite

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: We present a finite period general equilibrium model of an exchange economy with asymmetric information. We say that a rational expectations equilibrium exhibits an expected bubble if the price of an asset in one period is higher than any agent’s marginal valuation of holding the asset to maturity. We say the equilibrium exhibits a strong bubble if the price is higher than the dividend with probability one. We show that a necessary condition for an expected bubble to exist is that each agent must be short sale constrained at some period in the future with positive probability. We show that necessary conditions for a strong bubble to occur are that (1) each agent must have private information in the period and state in which the bubble occurs and (2) agents’ trades are not common knowledge. We also present examples of rational expectations equilibria that exhibit strict bubbles when the necessary conditions are satisfied.

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