Partial Equilibrium Thinking, Extrapolation, and Bubbles - Francesca Bastianello

Finance

Speaker : Francesca Bastianello (Chicago)

We develop a dynamic theory of “Partial Equilibrium Thinking” (PET), and provide a micro-foundation for time-varying price extrapolation. The two-way feedback between prices and beliefs is present at all times, but only sometimes manifests itself in explosive ways. In normal times, PET generates constant price extrapolation and momentum. By contrast, following a “displacement shock” that increases uncertainty, PET leads to stronger and time-varying extrapolation, triggering bubbles and endogenous crashes. Our theory sheds light on both normal times market dynamics and the Kindleberger (1978) narrative of bubbles within a unified framework.

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