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Growth Cycles and Market Crashes

David K. Levine and Michele Boldrin

October 31, 1997

Revised: January 16, 1999

Abstract: Stock market booms are often followed by dramatic falls. This is often viewed as a bad thing, and evidence of investor irrationality. To explain this from a fundamentalist point of view requires an asymmetry in the underlying technology shocks driving the market. Here we argue that a straightforward model of technological progress leads to clear asymmetries and that these asymmetries may also be the source of growth cycles. In a simple optimization model with a representative consumer, if traders are not too risk averse, we show that the stock market will generally rise, punctuated by occasional dramatic falls. This is first best. Surprisingly, if consumers are very risk averse, the gradual rise in the market will be broken by dramatic increases in stock prices on the occasion of bad news. Bad news does not correspond to a contraction of existing production possibilities, but rather to a decrease in the rate at which it expands. For this reason, this economy provides a model of endogenous growth in which the timing of recoveries and recessions is dictated by the pace at which technological innovations are adopted.