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DeLong: The Simplest Possible Behavioral Finance Bubble Model

There are, I think, two big questions in behavioral finance:

  1. Under what circumstances will normal, human behavior by investors produce forces in financial markets that drive them to speculative excess?

  2. Under what circumstances will arbitrageurs--smart, sophisticated investors who understand what is going on--fail to help the situation much?

A first whack at trying to answer (1):

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