3. Origin of Asset Price Bubbles

Brunnermeier (2009) considers a thinner classification of models. His classification contains two additional groups with elements of both rational and behavioral group. For the purpose of this book, we will focus on the most extreme versions. The interested reader is referred to the references in Brunnermeier (2009).

The importance of the “no short-selling” assumption is better understood with an example. In these behavioral models, agents have different beliefs on the future return on the asset. With the short-selling constraint, the marginal buyer of the asset will be an optimistic investor, who thinks that the return on the asset will be high. That is, the investor who hopes to profit from trading the asset is the one with “high expectations”. In contrast, if short-selling is possible, the marginal investor may be a pessimistic investor, who thinks that the return on the asset will be very low. An empirical justification for this assumption is that, in practice, it is costly to short sell a stock. The investor needs to borrow a stock and sell it. Then, she needs to repurchase the stock (at a hopefully lower price) to return it to the lender.

In our simple model, the assumption that guarantees that only behavioral investors purchase the risky asset is \(e > 2\sigma /\mu (1 + \pi )\). In words, we assume that behavioral agents have enough wealth.

Arce and Lopez-Salido (2011) also develop a rational housing bubble. They consider an economy where agents face heterogenous financial constraints and have the option to purchase or rent the house. We explain Basco (2014) because, in addition to the closed economy equilibrium, he investigates the effect of globalization on the emergence of housing bubbles, which will be the main topic of the next chapter.

In this book, we focus on housing bubbles. There exists a large literature that develops quantitative macroeconomic models to understand the effects (and causes) of housing booms. A recent important contribution is Favilukis et al. (2017), who emphasize financial liberalization as the driver of the recent US housing boom. The reader is referred to this paper and references within for further details.

The results do not depend on this specific financial constraint. Basco (2014) shows how the results extend to different types of borrowing constraints.

The housing supply elasticity is defined as (dH/dP)*(p/H), where dH/dP is the partial derivative of H with respect to p.

The fundamental demand, σ, follows directly from equations (R1) and (R4).