Bubbles and Market Crashes

TL;DR

This paper develops a dynamical model explaining how speculative trends lead to asset price bubbles and crashes, supported by computer experiments that confirm the theoretical predictions.

Contribution

It introduces a new dynamical theory linking speculative behavior to bubble formation and crashes, validated through computer simulations.

Findings

Bubbles form when speculative trends dominate fundamentals.

Asset prices deviate from fundamental values during bubbles.

Exogenous shocks trigger crashes when bubbles are large.

Abstract

We present a dynamical theory of asset price bubbles that exhibits the appearance of bubbles and their subsequent crashes. We show that when speculative trends dominate over fundamental beliefs, bubbles form, leading to the growth of asset prices away from their fundamental value. This growth makes the system increasingly susceptible to any exogenous shock, thus eventually precipitating a crash. We also present computer experiments which in their aggregate behavior confirm the predictions of the theory.