Diagnostic Bubbles

Pedro  Bordalo; Nicola  Gennaioli; Spencer Yongwook Kwon; Andrei   Shleifer

Working Paper | 2018

Diagnostic Bubbles

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

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.

Keywords: bubbles; Price Bubble; Mathematical Methods;

Language: English

Format: Print

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Citation:

Bordalo, Pedro, Nicola Gennaioli, Spencer Yongwook Kwon, and Andrei Shleifer. "Diagnostic Bubbles." NBER Working Paper Series, No. 25399, December 2018.

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Diagnostic Bubbles

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