Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.
Since asset prices affect the real allocation of an economy, it is important to understand the circumstances under which these prices can deviate from their fundamental value.
There are four main strands of models:
- all investors have rational expectations and identical information,
- investors are asymmetrically informed and bubbles can emerge because their existence need not be commonly known,
- rational traders interact with behavioural traders and bubbles persist since limits to arbitrage prevent rational investors from eradicating the price impact of behavioural traders,
- investors hold heterogeneous beliefs, potentially due to psychological biases, and agree to disagree about the fundamental value.