Antonio Doblas-Madrid

A Robust Model of Bubbles With Multidimensional Uncertainty

Boom-bust episodes in asset markets have often been interpreted by observers as speculative frenzies where asymmetrically informed investors buy overvalued assets hoping to sell to a greater fool before the crash. While intuitively appealing, this notion of speculative bubbles has been difficult to reconcile with standard economic theory. Existing models of speculation have been criticized on the basis that they assume irrationality, that prices are somewhat unresponsiveness to sales, or that they depend on fragile, knife-edge restrictions. To address these issues, I construct a rational version of Abreu and Brunnermeier (2003), where agents invest growing endowments into an asset, fueling appreciation and eventual overvaluation. Riding bubbles is optimal as long as the price grows quickly and there is a probability of exiting before the crash. This probability increases with the amount of noise in the economy, as random price flucutations make it difficult for agents to infer sales from the price.