Date Added: Jul 2009
Why are asset prices so much more volatile and so often detached from their fundamental values? Why does the bursting of financial bubbles depress the real economy? This paper addresses these questions by constructing an infinite-horizon heterogeneous agent general equilibrium model with speculative bubbles. The authors characterize conditions under which storable goods, regardless of their intrinsic values, can carry bubbles and agents are willing to invest in such bubbles despite their positive probability of bursting. They show that perceived changes in the bubbles' probability to burst can generate boom-bust cycles and produce asset price movements that are many times more volatile than the economy's fundamentals, as in the data.