A speculative bubble is a period when an asset’s price is sustained mainly by expectations that it can be sold later at a higher price, rather than by the asset’s underlying cash-flow fundamentals. Bubbles can occur in stocks, housing, commodities, and other assets, and they often end with a sharp correction or crash.
Fundamentals vs. Bubble Component
A standard way to frame the idea is to separate the price into a fundamental value plus an extra component:
\[ P_t = F_t + B_t \]
where F_t is the present value of expected future cash flows (discounted for time and risk) and B_t is a “bubble” component.
In a pure fundamental story, B_t = 0. In a bubble, B_t is positive because buyers are willing to pay more today partly because they expect to sell to someone else later.
Why Bubbles Can Grow
Bubbles are not just “people being irrational.” Several mechanisms can generate bubble-like dynamics:
- Feedback trading and narratives: rising prices attract attention and buyers, which pushes prices up further.
- Leverage: borrowing to buy assets increases demand on the way up and creates forced selling on the way down.
- Credit expansion: easy credit can amplify both price increases and subsequent crashes.
- Limits to arbitrage: even if some investors think prices are too high, short-selling and timing a crash can be difficult and risky.
Why They Matter For The Real Economy
When bubbles burst, the effects can spill into consumption, investment, and employment through:
- wealth effects,
- collateral values and credit supply,
- bank and shadow-bank balance sheets,
- confidence and expectations (“animal spirits”).
Related Terms
- Bubble
- Speculation
- Leverage
- Credit Cycle
- Financial Crisis
- Animal Spirits
- Risk Premium
- Mortgage-Backed Security (MBS)
- Sub-Prime Mortgage