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The Economics of Asset Prices: Understanding Bubbles and Speculation

Explore an economic model of asset prices, market equilibrium, bubble components, investment effects, and policy implications. Discover how bubbles impact investment growth. Simulation of economies with and without productivity shocks and policy interventions. Learn about managing bubbles for welfare enhancement.

anjolie-briggs
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The Economics of Asset Prices: Understanding Bubbles and Speculation

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  1. bombollesespeculatives Jaume Ventura CREI, UPF & Barcelona GSE Bojos per l’economia! Març 2014

  2. An Economic Model of Asset Prices • Assumptions • Time is a sequence of dates t=0,1,2,…,∞. • There is a market with traders willing to borrow and lend at the expected return of 1+r per period. • Question • What is the price of an asset that delivers pay-offs dt in date t? • Assume this asset is traded only in date 0.

  3. What future payments does the asset promise? • What is the expected value of these future payments? • How much are traders willing to pay today for these future payments?

  4. Market Equilibrium!!! • Letxnbe today’s value of payment at time n. Then, . . .

  5. How much are traders willing to pay today for these future payments? • How much are traders willing to pay today for the asset? • Thus, the price of the asset is

  6. Asset prices are high when expected payments are high and interest rates are low.

  7. Modifying our economic model of asset prices • We have assumed so far that the asset is traded at time 0 only. • Assume from now on that the asset is traded in all periods. • Can the ability to resell the asset modify its value?

  8. New Market Equilibrium!!! • Let pn be the price of the asset in date n. Then: . . . . . Iterating forever…

  9. Asset prices have a fundamental and a bubble component. • The bubble component is a pyramid scheme. • Self-fulfilling expectations play a crucial role in asset price fluctuations. Fundamental Bubble

  10. Calculating Fundamental and Bubble components • Measure the cash-flows that US productive assets generate as capital income, net of taxes and investment. • Compute the expected present discounted value of these cash-flows by assuming – • The interest rate is constant for all time horizons (equal to the 1950-2010 period average); and • Out-of-sample cash-flows grow at a constant rate (equal to the 1950-2010 period average), and resort to perfect foresight for within-sample cash-flows.

  11. Household Savings Investment Growth Firm Savings

  12. Household Savings Credit!!! Investment Growth Firm Savings

  13. Household Savings Credit!!! Investment Growth Firm Savings

  14. Back to theory (without equations!!) • Two effects of bubbles on investments • An increase in the size of bubbles today absorbs credit and lowers investment – CROWDING-OUT EFFECT. • An increase in the size of bubbles tomorrow provides collateral and raises investment – CROWDING-IN EFFECT. • What effects dominates? • If bubbles are not too large, the crowding-in effect dominates and bubbles raise investment and growth. • If bubbles become too large, the crowding-out effect dominates and bubbles lower investment and growth.

  15. Simulated Economy without Productivity Shocks and Policy

  16. Simulated Economy with Productivity Shocks and Without Policy

  17. Policy Implications for Central Banks • The behavior of the economy depends on self-fulfilling expectations and the bubble is sometimes too small and sometimes too large. • Central Banks can manage bubbles by taxing credit when the bubble is too large and subsidizing credit when the bubble is too low. • This policy raises welfare and has no fiscal cost.

  18. Simulated Economy without Productivity Shocks and with Policy

  19. Simulated Economy with Productivity Shocks and Policy

  20. bombollesespeculatives Jaume Ventura CREI, UPF & Barcelona GSE Bojos per l’economia! Març 2014

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