On the performance of West's bubble test: a simulation approach

Abstract

In this research we examine the ability of West’s bubble test [1] in detecting speculative bubbles using Brock’s (1982) [2] intertemporal general equilibrium model of asset pricing as the basis for a simulation study. In this setting, (1) the economy, by construction is effi- cient and produces the maximally possible amount of welfare for society, and (2) asset prices reflect the utility-maximizing behavior of consumers and the profit-maximizing behavior of firms. We find that the West’s bubble test flag as ‘‘bubbles” in the simulated data yet the data is produced from an economy in which markets are efficient in welfare production.