Working Paper: CEPR ID: DP8700
Authors: Tobias Broer; Afroditi Kero
Abstract: The fall in US macroeconomic volatility from the mid-1980s coincided with a strong rise in asset prices. Recently, this rise, and the crash that followed, have been attributed to overconfidence in a benign macroeconomic environment of low volatility. This paper introduces learning about the persistence of volatility regimes in a standard asset pricing model. It shows that the fall in US macroeconomic volatility since the mid-1980s only leads to a relatively small increase in asset prices when investors have full information about the highly persistent, but not permanent, nature of low volatility regimes. When investors infer the persistence of low volatility from empirical evidence, however, Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices.
Keywords: Asset Prices; Great Moderation; Macroeconomic Risk
JEL Codes: D83; E32; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inferred persistence of low volatility (C58) | asset prices (G19) |
| fall in US macroeconomic volatility (E39) | asset prices (G19) |
| Bayesian learning (C11) | asset prices (G19) |
| end of low volatility period (G14) | crash in asset prices (G01) |
| non-optimal adaptive learning schemes (C61) | overvaluation of assets (G32) |