Asset Bubbles and Overlapping Generations

This paper asks whether the standard “fundamentalist” view of asset pricing – that an asset’s price must equal the present discounted value of its dividends – extends to economies with overlapping generations, building on Diamond’s classic growth model with capital accumulation and various types of rents (assets that pay a real dividend). The paper derives necessary and sufficient conditions under which a “bubble” (a price in excess of market fundamental, on an asset that may or may not pay dividends) can exist and persist: bubbles crowd out productive savings, cannot grow faster than the economy, and can only exist, in the long run, if the interest rate that would prevail in the bubbleless, rentless economy is no greater than the population growth rate – so that a bubbleless equilibrium that is dynamically inefficient is precisely the case in which a bubbly equilibrium exists, and that bubbly equilibrium is the efficient one. An arbitrarily small reserve requirement on one intrinsically useless asset selects, among the many possible equilibria, the asymptotically bubbly path, giving institutions a role in equilibrium selection. The paper then draws out a series of further implications: an economy with such bubbles can reverse the usual variance-bound tests of stock-price fluctuations; money’s “market fundamental” (the value of its transaction services) and a pure bubble on money are shown to be mutually exclusive ways of giving money value, not merely two descriptions of the same thing; bubbles can be inefficient to create or can prevent a nonrenewable resource’s market fundamental from ever being exhausted; and for some assets the standard financial notion of “market fundamental” is not fully satisfactory and must be supplemented with a “real” market fundamental that serves as a lower bound on price.

Jean Tirole | Macro Paper Warehouse

Asset Bubbles and Overlapping Generations