Bubbles in a Simple Behavioral Finance Model

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Suppose participants in a financial market adopt either a "fundamentalist" or "chartist" trading strategy based on the historical, risk-adjusted profitability of each strategy. Fundamentalists bet that price will adjust (at a speed determined by the "speed-of-adjustment parameter") towards a value justified by economic fundamentals (the "fundamental value", assumed to follow a random walk). Chartists bet that price will follow its historical trend, such that a percentage (determined by the "extrapolation parameter") of the previous period's price movement will occur again. This Demonstration shows how deviations of price from fundamental value ("bubbles") are affected by the parameters of the trading strategy and the stochastic nature of the model.

Contributed by: Kevin W. Capehart (March 2011)
After work by: Paul De Grauwe and Marianna Grimaldi
Open content licensed under CC BY-NC-SA



See De Grauwe and Grimaldi (2006) for a detailed discussion of the model implemented here, as well as many extensions to it.

P. De Grauwe and M. Grimaldi, The Exchange Rate in a Behavioral Finance Framework, Princeton, NY and Oxford, UK: Princeton University Press, 2006.

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