Working Paper: CEPR ID: DP16368
Authors: Edouard Schaal; Mathieu Taschereau-Dumouchel
Abstract: This paper explores whether rational herding can generate endogenous aggregate fluctuations. We embed a tractable model of rational herding into a business cycle framework. In the model, technological innovations arrive with unknown qualities and agents have dispersed information about how productive the technology really is. Rational investors decide whether to invest based on their private information and the investment behavior of others. Herd-driven boom-bust cycles arise endogenously in this environment when the technology is unproductive but investors' initial information is unusually optimistic. Their overoptimism leads to high investment rates, which investors mistakenly attribute to good fundamentals, leading to a self-reinforcing pattern of higher optimism and higher investment until the economy reaches a peak, followed by a crash when agents ultimately realize their mistake. We calibrate the model to the U.S. economy and show that it can explain boom-and-bust cycles in line with episodes like the dot-com bubble of the 1990s.
Keywords: herding; booms and busts; bubbles; endogenous business cycles
JEL Codes: E32; D80
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| initial optimism (D84) | high investment rates (G31) |
| high investment rates (G31) | peak (Y60) |
| initial optimism (D84) | peak (Y60) |
| overoptimism (D84) | misattribution of investment to good fundamentals (G41) |
| misattribution of investment to good fundamentals (G41) | crash (G01) |
| initial optimism (D84) | crash (G01) |