A Theory of Asset Price Booms and Busts and the Uncertain Return to Innovation

Satyajit Chatterjee

Vice President and Economist

Q4 2011

Business Review — Many observers believe that turbulence in asset prices results from bouts of optimism and pessimism among investors that have little to do with economic reality. While psychology and emotions are no doubt important motivators of human actions, an explanation for asset price booms and busts that ignores the fact that humans are also thinking animals does not seem entirely satisfactory or plausible.

In this article, Satyajit Chatterjee presents a counterpoint to the view that “it’s all psychology.” He reports on a theory of asset price booms and busts that is based entirely on rational decision-making and devoid of psychological elements. The explanation suggests that asset price booms and crashes are most likely to occur when the value of the asset in question depends on an innovation whose full profit potential is initially unknown to investors.

This article appeared in the Fourth Quarter 2011 edition of Business Review.

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