Economic Implications of Extraordinary Movements in Stock Prices

MOST PEOPLE AGREE that stock prices sometimes behave in strange ways. Going beyond this simple observation typically proves more difficult. For at least the past quarter century, economists have been well aware that the variation of stock prices does not nicely match the familiar bell-shaped normal distribution.1 The problem is too many extreme movements. Very large increases or decreases would always be possible even if changes in stock prices were normally distributed, but they would occur only rarely. By contrast, actual stock prices rise or fall by large percentage amounts fairly often-certainly often enough to raise serious doubts that the usual normal distribution provides a useful way to think about how they vary. Economists and other analysts of the stock market have tended to react to this problem in either of two ways. The most common approach is simply to ignore it and go ahead to analyze changes in stock prices as