Beauty Contests and "Irrational Exuberance": A Neoclassical Approach

George-Marios Angeletos, Guido Lorenzoni () and Alessandro Pavan

No 1502, Discussion Papers from Northwestern University, Center for Mathematical Studies in Economics and Management Science

Abstract: The arrival of new, unfamiliar, investment opportunities is often associated with "exuberant" movements in asset prices and real economic activity. During these episodes of high uncertainty, financial markets look at the real sector for signals about the profitability of the new investment opportunities, and vice versa. In this paper, we study how such information spillovers impact the incentives that agents face when making their real economic decisions. On the positive front, we find that the sensitivity of equilibrium outcomes to noise and to higher-order uncertainty is amplified, exacerbating the disconnect from fundamentals. On the normative front, we find that these effects are symptoms of constrained inefficiency; we then identify policies that can improve welfare without requiring the government to have any informational advantage vis-a-vis the market. At the heart of these results is a distortion that induces a conventional neoclassical economy to behave as a Keynesian "beauty contest" and to exhibit fluctuations that may look like "irrational exuberance" to an outside observer.

Keywords: Incomplete information; beauty contests; exuberance; informational frictions; endogenous complementarities JEL Classification Numbers: C72; D62; D82 (search for similar items in EconPapers)
Date: 2010-03-05
References: View complete reference list from CitEc
Citations: View citations in EconPapers (42)

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Related works:
Working Paper: Beauty Contests and Irrational Exuberance: A Neoclassical Approach (2010)
Working Paper: Beauty Contests and Irrational Exuberance: A Neoclassical Approach (2010)
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