Testable Implications of Indeterminacies in Models with Rational Expectations

Robert P. Flood, Robert J. Hodrick

NBER Working Paper No. 2903
Issued in March 1989
NBER Program(s):International Trade and Investment, Monetary Economics, International Finance and Macroeconomics

The possibility that movements in market prices of assets or goods may be caused by self-fulfilling prophecies, called bubbles or sunspots, has long intrigued market observers. If bubbles or sunspots exist, market prices differ from their fundamental values, and markets do not necessarily allocate resources to their best possible uses. Some might argue then that public policies would be needed to alleviate such problems. This paper surveys the current state of the empirically-oriented literature concerning rational dynamic indeterminacies by which we mean a situation of self-fulfilling prophecy within a rational expectations model. The empirical work in this area concentrates primarily on indeterminacies in price levels, exchange rates and equity prices. We first examine a particular type of explosive indeterminacy, usually called a rational bubble, in a familiar model of equity pricing. We then consider empirical work relating to price level and exchange rate indeterminacies, before examining empirical studies of indeterminacies in stock prices. Finally, we take up some interpretive issues. We find that existing bubbles tests do not establish that rational bubbles exist in asset prices.

download in pdf format
   (197 K)

download in djvu format
   (175 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w2903

Published: The Journal of Economic Perspectives, vol.4, no.1, Winter 1990

Users who downloaded this paper also downloaded* these:
Froot and Obstfeld w3091 Intrinsic Bubbles: The Case of Stock Prices
Baldwin w2911 Sunk-Cost Hysteresis
Blanchard and Watson w0945 Bubbles, Rational Expectations and Financial Markets
Farmer, Nourry, and Venditti w18647 The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World
Lyons w4467 Optimal Transparency in a Dealership Market with an Application to Foreign Exchange
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us