A THREE-STATE RATIONAL GREATER-FOOL BUBBLE MODEL WITH INTERTEMPORAL CONSUMPTION SMOOTHING

Abstract

We construct a simple rational greater-fool bubble model, where the motive for trade is intertemporal consumption smoothing. This yields an easy-to-understand bubble model with three states of the world, instead of the five required previously. Bubbles are more likely when asset sellers have profitable investment opportunities, but little wealth, so they sell shares in those opportunities to wealthier investors. “Bad sellers” then pretend to sell similar investment opportunities, creating potential bubble assets. Bubbles are possible even if alternative means of consumption smoothing are available. Also, antibubble policy can reduce the welfare of even the greater fools it is supposed to protect.