Inflation—the rise in the price of goods and services—reduces the purchasing power each unit of currency can buy.
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Clifford Asness  Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return.
Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.
Herding[ edit ] Another related explanation used in behavioral finance lies in herd behaviorthe fact that investors tend to buy or sell in the direction of the market trend.
Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers.
This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits.
A person's belief that they are responsible for the consequences of their own actions is an essential aspect of rational behavior. An investor must balance the possibility of making a return on their investment with the risk of making a loss — the risk-return relationship.
A moral hazard can occur when this relationship is interfered with, often via government policy. Bush on 3 October to provide a Government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom condemned by a story in The Economist titled "The worldwide rise in house prices is the biggest bubble in history".
Other causes of perceived insulation from risk may derive from a given entity's predominance in a market relative to other players, and not from state intervention or market regulation. A firm — or several large firms acting in concert see carteloligopoly and collusion — with very large holdings and capital reserves could instigate a market bubble by investing heavily in a given asset, creating a relative scarcity which drives up that asset's price.
Because of the signaling power of the large firm or group of colluding firms, the firm's smaller competitors will follow suit, similarly investing in the asset due to its price gains.
When the large firm, cartel or de facto collusive body perceives a maximal peak has been reached in the traded asset's price, it can then proceed to rapidly sell or "dump" its holdings of this asset on the market, precipitating a price decline that forces its competitors into insolvency, bankruptcy or foreclosure.
The large firm or cartel — which has intentionally leveraged itself to withstand the price decline it engineered — can then acquire the capital of its failing or devalued competitors at a low price as well as capture a greater market share e.
Other possible causes[ edit ] Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles.
Others take the view that there is a "fundamental value" to an assetand that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value. There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors.
Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals". Experimental and mathematical economics[ edit ] Bubbles in financial markets have been studied not only through historical evidence, but also through experimentsmathematical and statistical works.Preliminary versions of economic research.
Did Consumers Want Less Debt? Consumer Credit Demand Versus Supply in the Wake of the Financial Crisis. Malaysia business and financial market news. The Star Online delivers economic news, stock, share prices, & personal finance advice from Malaysia and world. For investors, this can cause confusion, since inflation appears to impact the economy and stock prices, but not at the same rate.
(For related reading, see: What You Should Know About Inflation.). The exchange rate is the most important price in any economy, since it affects all other prices. Exchange rates are set, either directly or indirectly, by government policy.
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