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Noisy Rational Bubbles

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This paper develops a novel theory of price dynamics during bubble-like episodes in a tractable noisy rational expectations model with endogenous investor inflows. The unique linear partially revealing rational expectations equilibrium features a dramatic non-fundamental rise and fall of asset prices driven by speculation. Two layers of uncertainty—-uncertainty about the fundamental value and uncertainty regarding the probability with which the fundamental value is fully revealed in each period, can generate the hump shape in prices. Gradual investor inflows can greatly amplify price movements. Simulation results show that the model equilibrium can produce various real-life bubble-like events.

This talk is part of the Cambridge Finance Workshop Series series.

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