Rational Expectations Fools' Bubbles

Abstract

We develop a rational, Walrasian model of speculative bubbles inspired by the Kindleberger–Minsky view, which describes bubbles as wave-like market processes. Touched off by an initial shock, price booms are initially self-reinforcing but become self-destructive later when prices surpass fundamental value. Previous models in this vein have been criticized due to ad hoc features, such as prices driven by behavioral forces or particular trading protocols. Our model allays these concerns by relying only on multidimensional uncertainty to prevent unraveling via backward induction. Standard market clearing, moreover, makes the model more compatible with established macroeconomic and asset pricing frameworks.