Final Report Summary - BOOM & BUST CYCLES (Boom and Bust Cycles in Asset Prices: Real Implications and Monetary Policy Options)
The research project established to what extent stock price and house price fluctuations are influenced by sentiment factors (return optimism/pessimism) rather than by economic fundamentals (earning, interest rates, etc.). Analyzing survey data on return expectations of a wide set of investors, the project shows return expectations are influenced by observed past capital gains in a way that leads to return optimism when stock prices are high and return pessimism when stock prices are low. It formally shows that the observed degree of optimism/pessimism cannot be reconciled with the actual behavior of stock market returns. The project then constructs equilibrium asset pricing models in which investors' beliefs give rise to the kind of expectational biases documented in the survey data and shows how these models can give rise to realistic amounts of asset price volalitiy, including occasional boom-bust cycles. These boom-bust cycles occur even though investors are not assumed to suffer from behavioral biases. The economic models suggest that the overwhelming part of the price volatility observed in stock price data is due to the presence of subjective return beliefs rather than due to economic fundamentals alone. This provides a radically different view on the drivers of asset price volatility than advocated in standard asset pricing models. It also provides a radically different view on how policy should deal with asset price fluctuations. The project develops tools that allow characterizing how (monetary) policy can deal with situations in which subjective beliefs lead to a deviation of asset prices from their fundamental value and rationalizes - amongst other things - that central banks should "lean against" asset price movements.