A Bayesian's Bubble

  • Author(s): C. WEI LI, HUI XUE
  • Published: Nov 25, 2009
  • Pages: 2665-2701
  • DOI: 10.1111/j.1540-6261.2009.01514.x

ABSTRACT

The acceleration of the U.S. productivity growth in the late 1990s suggests a significant advance in technological innovation, making the perceived probability of entering a “new economy” ever increasing. Based on macroeconomic data, we identify a Bayesian investor's belief evolution when facing a possible structural break in the economy. We show that such belief evolution plays a significant role in explaining both the stock market boom and crash during 1998 to 2001. We conclude that a rational investor's uncertainty about the future of the U.S. economy provides an alternative explanation for the late 1990s stock market “bubble.”

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