Herschel I. Grossman

Bio: Herschel I. Grossman is an academic researcher from Brown University. The author has contributed to research in topics: Rational expectations & Consumption (economics). The author has an hindex of 11, co-authored 30 publications receiving 2394 citations.

Explosive Rational Bubbles in Stock Prices

Abstract: A number of recent studies address the problem of assessing the contributions of market fundamentals and rational bubbles to stock-price fluctuations-see, for example, Olivier Blanchard and Mark Watson, 1982; Robert Flood, Robert Hodrick, and Paul Kaplan, 1986; and Kenneth West, 1986, 1987. A rational bubble reflects a self-confirming belief that an asset's price depends on a variable (or a combination of variables) that is intrinsically irrelevant-that is, not part of market fundamentals-or on truly relevant variables in a way that involves parameters that are not part of market fundamentals. A basic difficulty involved in testing for the existence of rational bubbles, pointed out by Flood and Peter Garber, 1980, and emphasized by James Hamilton and Charles Whiteman, 1985, is that the contribution of hypothetical rational bubbles to asset prices would not be directly distinguishable from the contribution to market fundamentals of variables that the researcher cannot observe. For example, as Hamilton, 1986, shows, a researcher who is unable to observe or to infer changes in the expectations of market participants, especially if they involve the probable future occurrence of relevant events that are infrequent and discrete, might falsely conclude that rational bubbles exist. In the present context, the probabilities that investors attach to possibilities for future tax treatment of dividend income could act like such an unobservable variable. Diba and Grossman, 1984, and Hamilton and Whiteman, 1985, propose an empirical strategy based on stationarity tests for obtaining evidence against the existence of explosive rational bubbles without precluding the possible effect of unobservable variables on market fundamentals. The present paper implements such tests for explosive rational bubbles in stock prices using a model that assumes a constant discount rate, but that allows unobservable variables to affect market fundamentals and also allows different valuations of expected capital gains and expected dividends. If the first differences of the unobservable variables and the first differences of dividends are stationary (in the mean) and if rational bubbles do not exist, then the model implies that first differences of stock prices are stationary. The model also implies, using an argument adapted from John Campbell and Robert Shiller, 1987, that, if the levels of the unobservable variables and the first differences of dividends are stationary, and if rational bubbles do not exist, then stock prices and dividends are cointegrated of order (1,1). These theoretical results do not imply that the finding that first differences of stock prices are nonstationary, or that stock prices and dividends are not cointegrated, would establish the existence of rational bubbles. A finding that stock prices and dividends are not cointegrated could result from the nonstationarity of the unobservable variables in market fundamentals, and a finding that stock-price changes are nonstationary could result from the nonstationarity of changes in these unobservable variables. Such findings also could arise from the inappropriateness of the implicit assumption that dividends are generated by an ARIMA process. The converse inference, however, is possible. That is, evidence that first differences of stock prices have a stationary mean and/or evidence that stock prices are cointegrated with dividends would be evidence against *Research Department, Federal Reserve Bank of Philadelphia, Philadelphia, PA 19106, and Department of Economics, Brown University, Providence, RI 02912, respectively. The views expressed are solely those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System. We thank John Campbell, Robert Shiller, and anonymous referees for helpful comments on earlier versions of this paper.

Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation

Abstract: History suggests the following stylized facts about default on sovereign debt:(1) Defaults are associated with identifiably bad states of the world. (2) Defaults are usually partial, rather than complete.(3) Sovereign states usually are able to borrow again soon after a default. Motivated by these facts, this paper analyses a reputational equilibrium in a model that interprets sovereign debts as contingent claims that both finance investments and facilitate risk shifting. Loans are a useful device to facilitate risk shifting because they permit the prepayment of indemnities. Nevertheless, because the power to abrogate commitments without having to answer to a higher enforcement authority is an essential aspect of sovereignty, a decision by a sovereign to validate lender expectations about debt servicing depends on the sovereign's concern for its trust worthy reputation. A trustworthy reputationis valuable because it provides continued access to loans. A key aspect of the analysis is that lenders differentiate excusable default, which is associated with implicitly understood contingencies, from unjustifiable repudiation. In the reputational equilibrium, the short-run benefits from repudiation are smaller than the long-run costs from loss of a trustworthy reputation. Thus, although sovereigns sometimes excusably default, they never repudiate their debts. The reputational equilibrium can involve efficient risk shifting and efficient investment or it can involve a binding lending ceiling that limits risk shifting and can also restrict investment. The factors that tend to produce a binding lending ceiling include a high time discount rate for the sovereign, low-risk aversion forthe sovereign, and a low net return from the sovereign's investments.

Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation

Abstract: History suggests the following stylized facts about default on sovereign debt:(1) Defaults are associated with identifiably bad states of the world. (2) Defaults are usually partial, rather than complete.(3) Sovereign states usually are able to borrow again soon after a default. Motivated by these facts, this paper analyses a reputational equilibrium in a model that interprets sovereign debts as contingent claims that both finance investments and facilitate risk shifting. Loans are a useful device to facilitate risk shifting because they permit the prepayment of indemnities. Nevertheless, because the power to abrogate commitments without having to answer to a higher enforcement authority is an essential aspect of sovereignty, a decision by a sovereign to validate lender expectations about debt servicing depends on the sovereign's concern for its trust worthy reputation. A trustworthy reputationis valuable because it provides continued access to loans. A key aspect of the analysis is that lenders differentiate excusable default, which is associated with implicitly understood contingencies, from unjustifiable repudiation. In the reputational equilibrium, the short-run benefits from repudiation are smaller than the long-run costs from loss of a trustworthy reputation. Thus, although sovereigns sometimes excusably default, they never repudiate their debts. The reputational equilibrium can involve efficient risk shifting and efficient investment or it can involve a binding lending ceiling that limits risk shifting and can also restrict investment. The factors that tend to produce a binding lending ceiling include a high time discount rate for the sovereign, low-risk aversion forthe sovereign, and a low net return from the sovereign's investments.

The theory of rational bubbles in stock prices

Abstract: Free disposal of equity, which directly rules out the existence of negative rational bubbles in stock pric es, also imposes theoretical restrictions on the possible existence o f positive rational bubbles. The analysis in this paper shows that a positive rational bubble can start only on the first date of trading of a stock. Thus, the existence of a rational bubble at any date woul d imply that the stock has been overvalued relative to market fundame ntals since the first date of trading, and that prior to the first da te of trading the issuer of the stock and potential stockholders who anticipated the initial pricing of the stock expected that the stock would be overvalued. Copyright 1988 by Royal Economic Society.

Monetary Theory and Policy

Abstract: Part 1 Empirical evidence on money and output: introduction some basic correlations estimating the effect of money on output summary. Part 2 Money in a general equilibrium framework: introduction the Tobin effect money in the utility function summary appendix - the MIU approximation problems. Part 3 Money and transactions: introduction shopping-time models cash-in-advance models other approaches summary appendix - the CIA approximation problems. Part 4 Money and public finance: introduction bugdet accounting equilibrium seigniorage optimal taxation and seigniorage Friedman's rule revisited nonindexed tax systems problems. Part 5 Money and output in the short run: introduction flexible prices sticky prices and wages a framework for monetary analysis inflation persistence summary appendix problems. Part 6 Money and the open economy: introduction the Obstfeld-Rogoff two-country model policy coordination the small open economy summary appendix problems. Part 7 The credit channel of monetary policy: introduction imperfect information in credit markets macroeconomic implications does credit matter? summary. Part 8 Discretionary policy and time inconsistency: introduction inflation under discretionary policy solutions to the inflation bias is the inflation bias important? do central banking institutions matter? lessons and conclusions problems. Part 9 Monetary-policy operating procedures: introduction from instruments to goals the instrument-choice problem operating procedures and policy measures problems. Part 10 Interest rates and monetary policy: introduction interest-rate rule and the price level interest rate policies in general equilibrium models the term structure of interest rates a model for policy analysis summary problems.

Cointegration and Tests of Present Value Models

Abstract: In a model where a variable Y[sub t] is proportional to the present value, with constant discount rate, of expected future values of a variable y[sub t] the "spread" S[sub t]= Y[sub t] - [theta sub t] will be stationary for some [theta] whether or not y[sub t]must be differenced to induce stationarity. Thus, Y[sub t] and y[sub t] are cointegrated. The model implies that S[sub t] is proportional to the optimal forecast of [delta Y{sub t+1}] and also to the optimal forecast of S*[sub t], the present value of future [delta y{sub t}]. We use vector autoregressive methods, and recent literature on cointegrated processes, to test the model. When Y[sub t] is the long-term interest rate and y[sub t] the short-term interest rate, we find in postwar U.S. data that S[sub t] behaves much like an optimal forecast of S*[sub t] even though as earlier research has shown it is negatively correlated with [delta Y{sub t+1}]. When Y[sub t] is a real stock price index and y[sub t] the corresponding real dividend, using annual U.S. data for 1871-1986 we obtain less encouraging results for the model, al-though the results are sensitive to the assumed discount rate.