Abstract
This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock's return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles, and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents' estimates of risk. (JEL D81, D83, E32, G01, G12)
Original language | English |
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Pages (from-to) | 159-191 |
Number of pages | 33 |
Journal | American Economic Journal: Macroeconomics |
Volume | 3 |
Issue number | 3 |
DOIs | |
Publication status | Published - Jul 2011 |