Information Contamination, Market Crashes, and Overshooting

This paper provides the model of self-organized stock market crashes with overshooting. Unlike typical macroeconomic and finance models, an economy can experience a boom and bust without any aggregate exogenous shocks nor successive idiosyncratic shocks. Under the boom, the economy spontaneously moves toward a critical point and the crash with overshooting takes place. What matters for this story is the herding behavior of irrational agents and contamination of the price information. Irrational agents exhibit Ss-type behavior under ambiguous situations and this makes a portion of traders suddenly escape from a stock market when the information becomes imprecise enough. This first round escape may lead to the further escape of other traders as well as a tremendous price drop. The model also analyzes how the boom will end and its aftermath: crash with overshooting, stagnation, recovery, and even soft-landing scenario without discrete price drops are considered