Rational Expectations and Stock Market Bubbles

Franklin Allen and Andrew Postlewaite

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

Abstract: The paper is concerned with time-consistency problems caused by monetary policy in an open economy. The temptation to generate surprise inflation is shown to depend positively on the amounts of nominal debt issued by the government or issued by individuals. Private debt matters, because inflationary money growth causes redistribution between domestic residents and foreigners. A government that cares about the welfare of its residents will be tempted to inflate whenever it or its residents have issued nominal debt to foreigners. A net creditor position, however, may eliminate the time-consistency problem.

For the United States, these international considerations should become increasingly relevant as the country accumulates external deficits. My estimates indicate that the incentive to inflate more than doubled between 1982 and 1988. More than two-thirds of this increase was due to higher external debt, which was largely financed in nominal terms.

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Working Paper: Rational Expectations and Stock Market Bubbles (1991)
Working Paper: Rational Expectations and Stock Market Bubbles
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