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http://hdl.handle.net/10419/59032
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| Title: | | On the power and weakness of rational expectations: Logical fallacies, periodic bubbles and business cycles  |
| Authors: | | Gracia, Eduard |
| Issue Date: | | 2012 |
| Series/Report no.: | | Economics Discussion Papers 2012-27 |
| Abstract: | | A popular interpretation of the Rational Expectations/Efficient Markets hypothesis states that, if the hypothesis holds, then market valuations must follow a random walk. This postulate has frequently been criticized on the basis of empirical evidence. Yet the assertion itself incurs what we could call 'fallacy of probability diffusion symmetry': although market efficiency does indeed imply that the mean (i.e. expected) path must be a random walk, if the probability diffusion process is asymmetric then the observed path will most closely resemble not the mean but the median, which does not necessarily follow a random walk. To illustrate the implications, this paper develops an efficient markets model where the median path of Tobin's q ratio displays regular cycles of bubbles and crashes reflecting an agency problem between investors and producers. The model is tested against US market data, with results suggesting that such a regular cycle does indeed exist and is statistically significant. The aggregate production function in Gracia (Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function, 2011) is then put forward to show how financial fluctuations can drive the business cycle by periodically impacting aggregate productivity and, as a consequence, GDP growth. |
| Subjects: | | Rational Expectations efficient markets financial bubbles stock markets booms and crashes Tobin's q business cycles economic rents |
| JEL: | | E22 E23 E32 G12 G14 |
| Creative Commons License: | |  |
| Document Type: | | Working Paper |
| Appears in Collections: | | Economics: The Open-Access, Open-Assessment E-Journal - Discussion Papers
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