NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Spencer Yongwook Kwon

Department of Economics
Harvard University
1805 Cambridge Street
Cambridge, Mass 02138
United States

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Institutional Affiliation: Harvard University

NBER Working Papers and Publications

December 2018Diagnostic Bubbles
with Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer: w25399
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.
 
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