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RFS Advance Access originally published online on August 20, 2007
Review of Financial Studies 2008 21(1):19-50; doi:10.1093/rfs/hhm032
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Relative Wealth Concerns and Financial Bubbles

Peter M. DeMarzo
Stanford University

Ron Kaniel
Duke University

Ilan Kremer
Stanford University

Address correspondence to Peter M. DeMarzo, Stanford Graduate School of Business, Stanford, CA 94305, or e-mail: demarzo_peter{at}gsb.stanford.edu

JEL: G11, G12, D52, D53, D91, E43


  Abstract

We present a rational general equilibrium model that highlights the fact that relative wealth concerns can play a role in explaining financial bubbles. We consider a finite-horizon overlapping generations model in which agents care only about their consumption. Though the horizon is finite, competition over future investment opportunities makes agents' utilities dependent on the wealth of their cohort and induces relative wealth concerns. Agents herd into risky securities and drive down their expected return. Even though the bubble is likely to burst and lead to a substantial loss, agents' relative wealth concerns make them afraid to trade against the crowd.

We have benefited from comments by Maureen O'Hara (the editor), Chester Spatt, Johan Walden, Wei Xiong, and an anonymous referee as well as seminar participants at Brigham Young University, Carnegie Mellon, Duke University, Hebrew University of Jerusalem, Northwestern University, Stanford University, Tel-Aviv University, Washington University in St. Louis, University of Utah, University of Washington, University of Wisconsin, Virginia Tech, Caesarea Center Annual Conference, CEPR European Summer Symposium in Financial Market, Utah Winter Finance Conference, and the RFS conference at Indiana University.


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