Herding Through Booms and Busts

• Authors: Edouard Schaal.
• BSE Working Paper: 112234 | April 20
• Keywords: imperfect information , endogenous business cycles , information cascade , social learning , boom-and-bust
• JEL codes: E32, D80
• imperfect information
• endogenous business cycles
• information cascade
• social learning
• boom-and-bust

This paper explores whether rational herding can generate endogenous aggregate fluctuations. We embed a tractable model of rational herding into a business cycle framework. In the model, technological innovations arrive with unknown qualities, and agents have dispersed information about how productive the technology really is. Rational investors decide whether to invest based on their private information and the investment behavior of others. Herd-driven boom-bust cycles arise endogenously in this environment when the technology is unproductive but investors’ initial information is overly optimistic. Their overoptimism leads to high investment rates, which investors mistakenly attribute to good fundamentals, leading to a self-reinforcing pattern of higher optimism and higher investment until the economy reaches a peak, followed by a crash when agents ultimately realize their mistake. We calibrate the model to the U.S. economy and show that it can broadly explain boom-and-bust cycles like the dot-com bubble of the 1990s.