Rational Belief Bubbles

Abstract

We propose an extension of the class of expectations bubbles (REBs) to the more general beliefs setting of Kurz (1994a,b). In a potentially non-stationary but stationarizable environment, among an heterogenous population of agents, it is possible to hold more than one rational expectation. When but diverse beliefs converge (correlated beliefs), they do not cancel each other out in aggregate anymore. This can make them an object of speculation. Accounting for the fact that market efficiency has an intrinsic time dimension, we show that diverse but correlated beliefs can thus account for speculative bubbles, without the need for irrational agents or limits to arbitrage. Many of the shortcomings of REBs that make bubbles implausible can be overcome once we relax the ergodicity requirement. In particular, we argue that the hitherto unexplained bubble component of REBs corresponds to an extension of the state space in Kurz and Motolese (2011).