Johan Waldén
Haas School of Business
University of California
Berkeley, California
We study intrinsic bubbles in a dynamic general equilibrium model with multiple stocks and risk averse investors. The situation is shown to be quite different from the traditional partial equilibrium model which assumes constant risk adjusted discount rates. First, bubbles in our model can burst endogenously, leading to discontinuous price changes for arbitrary small changes in fundamentals. Second, bubbles can not arise with fully rational investors, even with infinite time horizons. A weaker type of rationality -- local rationality -- is needed for bubbles to be possible. With finite time horizons however, bubbles arise under weaker conditions in our model than in the traditional model. Third, stock price dynamics will be governed by a system of nonlinear PDEs, providing a rich structure of cross-stock dynamics. For example, a "bubble sector" will influence price dynamics in the rest of the "no bubble" economy. Moreover, within a "bubble sector," changes of fundamentals for one stock will influence the likelihood of a crash in other stocks. The model has several empirical predictions. Tests indicate that the model has predictive power and that stock price behavior at the end of the millennium was in line with the presence of a bubble in the high-tech sector.