Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/59032
Authors: 
Gracia, Eduard
Year of Publication: 
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: 
http://creativecommons.org/licenses/by-nc/2.0/de/deed.en
Document Type: 
Working Paper

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