The Macroeconomics of Financial Speculation

I review the literature on financial speculation driven by belief disagreements from a macroeconomics perspective. To highlight unifying themes, I develop a stylized macroeconomic model that embeds several mechanisms. With short-selling constraints, speculation can generate overvaluation and speculative bubbles. Leverage can substantially inflate speculative bubbles, and leverage limits depend on perceived downside risks. Shifts in beliefs about downside tail scenarios can explain the emergence and the collapse of leveraged speculative bubbles. Speculative bubbles are related to rational bubbles, but they match better the empirical evidence on the predictability of asset returns. Even without short-selling constraints, speculation induces procyclical asset valuation. When speculation affects the price of aggregate assets, it also influences macroeconomic outcomes such as aggregate consumption, investment, and output. Speculation in the boom years reduces asset prices, aggregate demand, and output in the subsequent recession. Macroprudential policies that restrict speculation in the boom can improve macroeconomic stability and social welfare. Expected final online publication date for the Annual Review of Economics, Volume 13 is August 2021. Please see http://www.annualreviews.org/page/journal/pubdates for revised estimates.

Market Depth, Leverage, and Speculative Bubbles

We develop a model of rational bubbles based on leverage and the assumption of an imprecisely known maximum market size. In a bubble, traders push the asset price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. Households optimally decide whether to lend to traders with limited liability. Bubbles increase welfare of the initial asset holders, but reduce welfare of future households. We provide general conditions for the possibility of bubbles depending on uncertainty about market size, traders’ degree of leverage, and the risk-free rate. This allows us to discuss several policy measures. Capital requirements and a correctly implemented Tobin tax can prevent bubbles. Implemented incorrectly, however, these measures may create the possibility of bubbles and can reduce welfare.

A generalized approach to indeterminacy in linear rational expectations models

We propose a novel approach to deal with the problem of indeterminacy in linear rational expectations models. The method consists of augmenting the original state space with a set of auxiliary exogenous equations to provide the adequate number of explosive roots in presence of indeterminacy. The solution in this expanded state space, if it exists, is always determinate, and is identical to the indeterminate solution of the original model. The proposed approach accommodates determinacy and any degree of indeterminacy, and it can be implemented even when the boundaries of the determinacy region are unknown. Thus, the researcher can estimate the model using standard software packages without restricting the estimates to the determinacy region. We combine our solution method with a novel hybrid Metropolis–Hastings algorithm to estimate the New–Keynesian model with rational bubbles by Galí (2021) over the period 1982:Q4–2007:Q3. We find that the data support the presence of two degrees of indeterminacy, implying that the central bank was not reacting strongly enough to the bubble component.

Rational Bubbles in UK Housing Markets: Comment on “No‐Bubble Condition: Model‐Free Tests in Housing Markets”

Giglio, Maggiori, and Stroebel (2016) show that there is no significant price difference between freeholds and ultra‐long leaseholds in the UK housing market. They claim that this finding precludes the presence of large rational bubbles, as these can only attach to the price of freeholds. But the conclusion presumes that leaseholders cannot acquire bubbles through enfranchisement at favorable prices. We find that the presumption is violated. Enfranchisement rights are comprehensive and cheap to exercise. We also dispute the counter‐argument that cheap enfranchisement proves that market participants, if they have rational expectations, must have explicitly concluded that freehold prices are bubbleless.

Reply to “Rational Bubbles in UK Housing Markets”

In Giglio, Maggiori, and Stroebel (2016), we propose and implement a new test for classic rational bubbles. Such bubbles derive their value from each agent's rational expectation of being able to resell the bubble claims to the next agent. Backward induction ensures that classic rational bubbles can only exist on infinite‐maturity assets. Our empirical exercise shows that infinite‐maturity claims and 999‐year claims for otherwise identical housing assets trade at the same price, and thus rules out the presence of classic rational bubbles. Domeij and Ellingsen (DE) informally propose an alternative equilibrium of a bubble that they claim is consistent with our empirical findings. DE's bubble relies on information frictions such that market participants are unaware of the bubble. Our paper clearly excluded this type of bubble from the scope of our test, and DE's note thus has no implications for the validity of our test. Instead, DE's bubble simply represents one of many possible examples of bubbles on which our test was explicitly silent.

Herd Behavior and Volatility Persistence in Bombay (Mumbai) Stock Exchange

This paper employs a combination of unit root tests and fractional integration techniques using the ARFIMA(p,d,q) model to test rational bubbles, which implies herd behavior, in Bombay Stock Exchange (BSE). The results in the paper strongly support the evidence of herd behavior in the daily, weekly, and monthly price aggregates. Moreover, the paper also investigates the degree of conditional volatility persistence using FIGARCH(p,d,q) specification to show that the persistence of shocks to stock price and dividend yield volatilities is short-termed.