Asset Market Volatility and New Keynesian Macroeconomics: A Game-Theoretic Approach

Abstract

This study develops a game-theoretic approach to asset market bubbles. In our model, portfolio investments consist of risk-free and risky assets. Risky assets attract more investors who may adopt a hawk strategy, because they promise a higher return than risk-free assets. However, the economy falls into a full-blown crisis state when the portion of investment devoted to risky assets exceeds a threshold. Furthermore, we incorporate the periodic bubbles in asset markets into a New Keynesian baseline model. Our simulation results show that high volatility in asset markets increases the variability of inflation and output dynamics, while uncertainty about the dynamic economy can be amplified and hence may be seen as shocks for an inefficient distribution of wealth.