Diagnostic Bubbles

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

No 25399, NBER Working Papers from National Bureau of Economic Research, Inc

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 two well-known mechanisms: 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, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.

JEL-codes: G12 G4 (search for similar items in EconPapers)
Date: 2018-12
New Economics Papers: this item is included in nep-mic
Note: AP
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Published as Pedro Bordalo & Nicola Gennaioli & Spencer Yongwook Kwon & Andrei Shleifer, 2020. "Diagnostic Bubbles," Journal of Financial Economics, .

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