How do we define asset bubble?
In simple form, separate the price of an asset into two components, first is the underlying economic fundamentals and second is the non-fundamental bubble that may reflect price speculation or irrational investor euphoria or depression.
How bad bubbles are?
First we examine how asset prices influence inflation and aggregate economic activity. Asset bubbles can act through various channels to shift the Aggregate Demand Curve to the right:
Consumption - rising asset prices increase accumulated wealth and create wealth effect on households, also household’s positive expectation about future will boost their confidence to spend more.
Investment - asset prices provide signals regarding profitable investments. For example, higher equity prices driven by bubble-type factors like "irrational exuberance" create over-optimistic business forecast and boost business investment by lowering the cost of capital.
Government - asset price bubbles distort government financing decisions as well. As equity prices rise, tax revenues tied to capital gains go up. Government tends to spend more as revenue increase.
Without the support of fundamentals such as lower interest rates or faster productivity growth, the above factors will only shift the AD curve to the right and meet the SRAS curve at a higher price and higher output level, creating an “inflationary output gap”. In economic model, under the long run scenario, when the input resource prices have been fully adjusted to changes in the price level, the SRAS curve will shift up and the AD, SRAS and LRAS will meet again on a new equilibrium resuming the potential GDP but with a higher price than before, in the long run real variables are unchanged and the whole economy is not better off by any increase in production but is worst off by the leaving an inflation.
Apart from resulting misallocation of economic resources due to the wrong signal delivered, there are other possible damages asset price bubbles do to companies' investment decisions, households' investment and saving decisions, and the government's fiscal policy decisions:
For firms, unjustifiably high equity prices make it too easy to obtain financing. The feeding frenzy of a bubble allows people to sell shares for prices that are impossible to justify. Examples are internet companies that were easy to raise fund in equity markets in the 1990s crash and burn several years later. The funds they used could clearly have been better invested elsewhere. Not only that, but also this episode has now made it difficult for high-tech startup companies to obtain any financing at all. Following a bubble, the structure of the economy can take years to recover.
The impact of equity and property price bubbles on consumer behavior is equally damaging. When the bubble eventually bursts, wealth is recomputed and consumers are left with houses and mortgages that are too large for their paychecks, and investment accounts that are shadows of what they once were.
Asset price bubbles distort government financing decisions as well. As equity prices rise, tax revenues tied to capital gains go up. Increased government revenue leads to increases expenditure and cuts in taxes. With the bursting of the bubble, tax revenues have fallen dramatically. In the current political environment, it is impossible to raise taxes, and so the result is a combination of expenditure cuts and increased borrowing. At least a part of the current American fiscal imbalance is a consequence of the internet bubble of the late 1990s.
The even more harmful is when a bubble burst, it may cause severe strains on the financial system and destabilize the economy and even the society, take the recent drop in house price of US as example:
Contributed to a major shock to the financial system, with sharp increases in credit spreads and large losses to financial institutions. Leading to slowing of economic...
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