Identifying a stock price bubble and its macroeconomic implications

Abstract

We construct a present-value model with a rational bubble identified using stock market data and survey expectations. The model captures the 1970s “nifty-fifty” bubble, the dot-com bubble, the bubble prior to the 2007–2009 recession, a COVID-19 bubble, and a recent bubble possibly linked to artificial intelligence. When bubble-adjusting the price–dividend ratio, we no longer find explosive dynamics and excess volatility in stock prices. To examine the macroeconomic implications of a bubble, we use the bubble innovation as an instrument in a structural vector autoregression. The results show that a positive bubble shock is expansionary and leads to a higher monetary policy rate.