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Predicting the unpredictable: Forecastable bubbles and business cycles under rational expectations

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  • Gracia, Eduard

Abstract

A popular interpretation of the Rational Expectations/Efficient Markets hypothesis states that, if it holds, market valuations must follow a random walk; hence, the hypothesis is frequently criticized on the basis of empirical evidence against such a prediction. Yet this reasoning incurs what we could call the 'fallacy of probability diffusion symmetry': although market efficiency does indeed imply that the mean (i.e. 'expected') path must rule out any cyclical or otherwise arbitrage-enabling pattern, if the probability diffusion process is asymmetric the observed path will most closely resemble not the mean but the median, which is not subject to this condition. In this context, this paper develops an efficient markets model where the median path of Tobin's q ratio displays regular, periodic cycles of bubbles and crashes reflecting an agency problem between investors and producers. The model is tested against U.S. market data, and its results suggest that such a regular cycle does indeed exist and is statistically significant. The aggregate production model in Gracia (Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function, 2011) is then put forward to show how financial fluctuations can drive the business cycle by periodically impacting aggregate productivity and, as a consequence, GDP growth.

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  • Gracia, Eduard, 2012. "Predicting the unpredictable: Forecastable bubbles and business cycles under rational expectations," Economics - The Open-Access, Open-Assessment E-Journal (2007-2020), Kiel Institute for the World Economy (IfW Kiel), vol. 6, pages 1-43.
    • Handle: RePEc:zbw:ifweej:201241
    DOI: 10.5018/economics-ejournal.ja.2012-41
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    More about this item

    Keywords

    rational expectations; efficient markets; financial bubbles; stock markets; booms and crashes; Tobin's q; business cycles; economic rents;
    All these keywords.

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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