theory

Introduction A speculative bubble refers to a situation where asset prices exceed the asset’s fundamental value, driven by traders’ expectations of selling at even higher prices in the future. Traditional finance theory often argues that fully rational agents with common knowledge should not engage in trades that create bubbles – by backward induction in finite horizons or transversality conditions in infinite horizons, prices shouldn’t rise above discounted fundamentals.

The Model The model will feature the following three properties: Asymmetric The cost to decrease prices is a small constant while the cost to increase prices is positive and increasing in the size of price adjustment.