Working Paper: NBER ID: w15883
Authors: Georgemarios Angeletos; Guido Lorenzoni; Alessandro Pavan
Abstract: The arrival of new, unfamiliar, investment opportunities is often associated with "exuberant" movements in asset prices and real economic activity. During these episodes of high uncertainty, financial markets look at the real sector for signals about the profitability of the new investment opportunities, and vice versa. In this paper, we study how such information spillovers impact the incentives that agents face when making their real economic decisions. On the positive front, we find that the sensitivity of equilibrium outcomes to noise and to higher-order uncertainty is amplified, exacerbating the disconnect from fundamentals. On the normative front, we find that these effects are symptoms of constrained inefficiency; we then investigate policies that can improve welfare in our model without any informational advantage on the government's part. At the heart of these results is a distortion that induces a conventional neoclassical economy to behave as a Keynesian "beauty contest" and to exhibit fluctuations that may look like "irrational exuberance" to an outside observer.
Keywords: Beauty Contests; Irrational Exuberance; Neoclassical Economics; Investment Opportunities; Information Spillovers
JEL Codes: D82; E20; E44; G10; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| noise (Q53) | economy response (E29) |
| entrepreneurs' expectations about asset prices (D84) | investment decisions (G11) |
| investment decisions (G11) | fluctuations in asset prices (E32) |
| amplified responses (E71) | constrained inefficiency (D61) |
| mispricing in financial markets (G19) | suboptimal investment decisions (G11) |
| entrepreneurs' actions (L26) | market signals (G10) |
| investment (G31) | asset prices (G19) |