DP823 Informational Overshooting, Booms and Crashes
This paper offers an informational explanation for asset price booms and crashes. If market fundamentals change, but the length of this process of change is unknown, market participants try to learn about it by observing market outcomes. This learning generates a boom and a crash, which we call `informational overshooting'. The paper applies this idea to real-estate markets, to exchange markets and to stock markets. It shows that entry of a new group of investors to a stock market can generate such a boom and a crash. One implication of this result is that financial liberalizations tend to be followed by stock market booms and crashes.