Mathematics and Economics

Posts Tagged ‘Asymmetric Information’

Bubbles and Crashes: Motivation and Initial Reading List

In Asset Pricing Reading Group, Bubbles and Crashes, Economics, Finance on November 10, 2009 at 3:57 pm

“I can calculate the motions of the heavenly bodies, but not the madness of people.”

— Sir Isaac Newton after losing £20,000 in the South Sea Bubble

Bubbles and their subsequent crashes have confounded historians, economists, financiers and the general populous throughout history.  Examples, often categorized as bubbles, include Tulip Mania, the South Seas bubble, the Dot Com bubble, and the recent housing bubble.  The importance of bubbles and crashes cannot be overlooked, and the housing bubble is a prime example: as a consequence of the crash, global GDP (the cumulative GDP of every country) was severely affected. Much of the literature in macroeconomics ignored the consequences of bubbles by ignoring financial intermediation and associated frictions.  In light of the recent crises, the literature is now shifting toward an approach that brings together financial economics, monetary economics, and standard macroeconomic techniques.

An asset bubble is formed when an asset’s price is significantly different from its fundamental value, also known as its intrinsic value. In practice it is sometimes calculated as the discounted sum of expected future income; however, this may not be a good estimate to the actual fundamental value. In order to calculate the true fundamental value, we must first construct a general equilibrium model such as Milgrom & Stokey 1982 or Tirole 1982. Read the rest of this entry »