DP9532 Noise Bubbles

Author(s): Mario Forni, Luca Gambetti, Marco Lippi, Luca Sala
Publication Date: June 2013
Keyword(s): Noise shocks, Rational bubbles, Structural VARs
JEL(s): C32, E32, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9532

We introduce noisy information into a standard present value stock price model. Agents receive a noisy signal about the structural shock driving future dividend variations. The resulting equilibrium stock price includes a transitory component ? the "noise bubble" ? which can be responsible for boom and bust episodes unrelated to economic fundamentals. We propose a non-standard VAR procedure to estimate the structural shock and the "noise" shock, their impulse response functions and the bubble component of stock prices. We apply such procedure to US data and find that noise explains a large fraction of stock price volatility. In particular the dot-com bubble is entirely explained by noise. On the contrary the stock price boom peaking in 2007 is not a bubble, whereas the following stock market crisis is largely due to negative noise shocks.