Following up on this post, I gave the second lecture of my graduate course on asset price bubbles on October 22nd.
I started by discussing how rumors (say mean--reverting shocks not related to fundamentals) can be incorporated into an asset price in a way that is compatible with the fact that observed prices are not very forecastable, as explained by Robert Shiller in a paper on social dynamics. I then further explained the idea that prices can deviate from fundamentals because of irrational traders using a famous paper by Brad DeLong, Andrei Shleifer, Larry Summers and Robert Waldmann on noise trader risk. I concluded with a discussion of the equally famous paper by Andrei Shleifer and Robert Vishny on limits of arbitrage when investors use other people's money and are subject to performance reviews.
The point is that these "market inefficiencies" can lead to asset prices which deviate a lot from their fundamental values in a way that is different from the rational bubbles discussed in the first lecture. In particular, these inefficiency bubbles are not necessarily "growing bubbles", and therefore not subject to the type of transversality conditions that are typically used to rule out rational bubbles.
Specific mechanisms for the formation of these inefficiency bubbles will be discussed in the next lecture.
All references for the course can be found here.
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