Partial Equilibrium Thinking, Extrapolation, and Bubbles
Abstract
Abstract We develop a dynamic theory of “Partial Equilibrium Thinking” (PET), which micro-founds time-varying return extrapolation: extrapolative beliefs are present at all times, but only sometimes manifest themselves in explosive ways. We formalize the distinction between normal times shocks and “displacement shocks,” and study their interaction with extrapolative beliefs. In normal times, PET generates constant extrapolation and momentum. After a displacement shock that increases uncertainty, PET leads to stronger and time-varying extrapolation, triggering bubbles and endogenous crashes. Our theory sheds light on both market dynamics in normal times and Kindleberger’s narrative of bubbles within a unified framework.
Fields of Study & Subjects
Economic theories and models
Publication details
- Journal / source
- Review of Financial Studies
- Publisher
- Oxford University Press (OUP)
- Volume
- 39
- Issue
- 10
- Pages
- 3122-3190
- Publication date
- 30 May 2026
- Language
- EN