DP8700 | Great Moderation or Great Mistake: Can rising confidence in low macro-risk explain the boom in asset prices?

Publication Date

01/12/2011

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Abstract

The fall in US macroeconomic volatility from the mid-1980s coincided with a strong rise in asset prices. Recently, this rise, and the crash that followed, have been attributed to overconfidence in a benign macroeconomic environment of low volatility. This paper introduces learning about the persistence of volatility regimes in a standard asset pricing model. It shows that the fall in US macroeconomic volatility since the mid-1980s only leads to a relatively small increase in asset prices when investors have full information about the highly persistent, but not permanent, nature of low volatility regimes. When investors infer the persistence of low volatility from empirical evidence, however, Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices.