Speculative growth, overreaction, and the welfare cost of technology-driven bubbles

This paper develops a general equilibrium model to examine the quantitative effects of speculative bubbles on capital accumulation, growth, and welfare. A near-rational bubble component in the model equity price generates excess volatility in response to observed technology shocks. In simulations, intermittent equity price run-ups coincide with positive innovations in technology, investment and consumption booms, and faster trend growth, reminiscent of the U.S. economy during the late 1920s and late 1990s. The welfare cost of speculative bubbles depends crucially on parameter values. Bubbles can improve welfare if risk aversion is low and agents underinvest relative to the socially optimal level. But for higher levels of risk aversion, the welfare cost of bubbles is large, typically exceeding 1% of annual consumption.

► Develops a general equilibrium model to examine the quantitative effects of bubbles on capital accumulation, growth, and welfare.
► A near-rational bubble component in equity price generates excess volatility in response to observed technology shocks.
► Intermittent equity price run-ups coincide with positive innovations in technology, investment and consumption booms, and faster trend growth.
► Given typical parameter settings, the welfare cost of bubbles is large, typically exceeding 1% of annual consumption.