Partial Equilibrium Thinking, Extrapolation, and Bubbles [Job Market Paper]

Citation:

Francesca Bastianello and Paul Fontanier. Working Paper. “Partial Equilibrium Thinking, Extrapolation, and Bubbles [Job Market Paper]”.

Abstract:

We model a financial market where some agents mistakenly attribute any price change they observe to new information alone, when in reality part of the price change is due to other agents’ buying/selling pressure, a form of bounded rationality that we refer to as “Partial Equilibrium Thinking” (PET). PET provides a micro-foundation for price extrapolation, where the degree of extrapolation depends on the informational edge of informed agents. In normal times, this edge is constant and bubbles and crashes do not arise.  By contrast, following a large one-off innovation in fundamentals that temporarily wipes out informed agents' edge (a “displacement event”), extrapolation by PET traders is initially very aggressive but then gradually dies down, leading to bubbles and endogenous crashes. Micro-founding the degree of extrapolation in this way allows us to shed light on both normal market dynamics and on the Kindleberger (1978) narrative of bubbles within a unified framework.
Last updated on 01/01/2022