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 con- verge (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).
Highlights
In the following, we provide some addenda and modifications to the work of Kurz and Motolese [3]
Just as lines and circles are useful abstractions even though they do not exist in the real world [10, 11], the “purity” of the setting in which bubbles are theorized is of practical import: If frictions are a necessary condition of bubbles, the policy implication is that the regulator should focus on perfecting markets, pushing ever further the “financialization” of the economy [but see 12, 13]
Might say there is really only one model once we move up a level of abstraction: In the corner cases, when individual beliefs are either independent or comonotonic, the equilibrium price conforms to rational expectations; when they are dependent, the market extends its state space through the endogenous market belief variable
Summary
We provide some addenda and modifications to the work of Kurz and Motolese [3]. The persistent diversity of expectations adds a strategic element to the decision calculi of agents, enlarging the state space of the model by an endogenous variable called “market belief.”. One. might say there is really only one model once we move up a level of abstraction: In the corner cases, when individual beliefs are either independent or comonotonic, the equilibrium price conforms to rational expectations; when they are (imperfectly) dependent, the market extends its state space through the endogenous market belief variable. It is interesting to note that “correlated beliefs” in [3] refers to correlated innovations to individual beliefs This means that, as the market belief variable appears, belief states converge, lending additional support to our contention that the endogenous state variable is the hitherto unexplained “bubble component” of rational bubbles.
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