Rational Asset Pricing Bubbles Revisited

Jan Werner (University of Minnesota)
Monday, December 12, 2011 - 2:15pm
Spandauer Strasse 1, Room 23

Price bubble arises when the price of an asset exceeds the asset's fundamental value, that is, the present value of future dividend payments. The important result of Santos and Woodford (1996) says that price bubbles cannot exist in equilibrium in the standard dynamic asset pricing model with rational agents as long as assets are in strictly positive supply and the present value of total future resources is finite. This paper explores the possibility of asset price bubbles when either one of the sufficient conditions for non-existence of bubbles is violated. We demonstrate that there always exist equilibria with price bubbles on assets in zero supply. We argue that many assets should be considered as being in zero supply. Further, we show that endogenous debt constraints generated by limited enforcement of trade are in a certain sense most prone to give rise to equilibrium price bubbles on assets in strictly positive supply and with infinite present value of total resources.