No 164. Bubbles and crashes in a behavioural finance model

by Paul De Grauwe and Marianna Grimaldi

Abstract: We develop a simple model of the exchange rate in which agents optimize their portfolio and use di?erent forecasting rules. They check the profitability of these rules ex post and select the more profitable one.This model produces two kinds of equilibria, a fundamental and a bubble one. In a stochastic environment the model generates a complex dynamics in which bubbles and crashes occur at unpredictable moments. We contrast these "behavioural" bubbles with "rational" bubbles.

Keywords: exchange rate, bounded rationality, heterogeneous agents,
bubbles and crashes, complex dynamics.

JEL classification: F31, F41, G10.