This paper introduces, within the context of an infinite horizon optimal consumption problem, a parametric class of Kreps-Porteus nonexpected utility preferences—generalized isoelastic utility—which distinguishes attitudes toward risk from behavior toward intertemporal substitution. Some of the theoretical and empirical implications for macroeconomics of these state- and time-nonseparable preferences are examined.

It is often argued that a rational bubble, because it is positive, must increase the price of a stock. This argument is not valid in general: as soon as bubbles affect interest rates, the fundamental value of a stock depends on whether or not a bubble is present. The existence of a rational bubble then might, by raising equilibrium interest rates, depress the fundamental to such an extent that the sum of the positive bubble and decreased fundamental falls short of the fundamental, no-bubble price. Under conditions made precise below, there can therefore be price decreasing bubbles, and an asset can be undervalued.