Bubbles and Crashes

This chapter explains the financial bubble that occurs when a financial asset deviates from its fundamental value. In a financial bubble, there is a sudden price surge that doesn’t seem to be related in any clear and evident way to its fundamental value; investors buy the overvalued asset because they assume that the asset price will continue to rise in the future. The example of the tulip bulb bubble in the Netherlands is given, as well as the US housing bubble of the early 2000s. Even if they are somewhat rare, housing bubbles and housing crashes do exist; they have elements of rationality to them, even if the collective behavior involved is irrational, and the bubbles misallocate resources and distort the flow of the real economy.

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