Intertemporal Information Loss and Asset Price Cycles

Abstract

This paper studies a simple model with information and business cycles to explain an endogenous bust. In such a cycle, a booming economy experiences a bust despite the absence of an exogenous trigger shock; instead, increasing economic activity in a boom state itself causes a crash. The key is a feedback loop between investment activity and the efficiency of a public signal that aggregates information and determines the aggregate risk. High-risk and low economic activity augment each other (positive feedback), making the downturn state stable. In a low-risk and high-activity state, however, the feedback can be reversed: stronger activity contaminates the public signal, generating an increase in the risk and subsequent decline in investment. As a switch from positive to negative feedback is governed by the endogenous level of economic activity, a transition from boom to crash is explained as an endogenous event.