Working Paper: NBER ID: w25399
Authors: Pedro Bordalo; Nicola Gennaioli; Spencer Yongwook Kwon; Andrei Shleifer
Abstract: We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.
Keywords: price bubbles; diagnostic expectations; speculation; learning from prices
JEL Codes: G12; G41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| diagnostic expectations (D84) | price dynamics (E30) |
| initial underreaction to good news (G41) | price overshooting (E30) |
| excessive optimism (D84) | price overshooting (E30) |
| price overshooting (E30) | crash (G01) |
| diagnostic expectations (D84) | overreaction to good news (G41) |
| overreaction to good news (G41) | prices exceeding fundamental values (D46) |
| speculation (D84) | price inflation (E31) |
| price dynamics (E30) | bubbles (E32) |