12.2 Asset Bubbles #Notebook

12.2 Asset Bubbles #Notebook

Low interest rates can cause bubbles by lowering the total cost of asset ownership. Interest rates and bond prices are inversely related. The PV formula, PV = FV/(1 + i)n

In colonial New York about the 1740s, interest rates on mortgages were generally 8%. In the late 1750s and early 1760s, they fell to about 4%, and expected revenues from land ownership increased by around 50%. 

What happened to real estate prices? 

The land was expected to create higher revenues.

The real estate prices rose significantly because it was cheaper to borrow money, and the total cost of real estate ownership was lower. 

Thinking of the land as a perpetuity and FV as the expected revenues arising from it:

PV = FV / i 

PV = £100 / .08 = £1,250 

PV = £100 / .04 = £2,500

The effect of new technology can increase FV, leading to a higher PV. 

Large increases in the demand for an asset occur when investors’ expectations of higher prices in the future.

In the Gordon growth model

Lower interest rates decrease k(required return) and new inventions increase g (constant growth rate).

 P = E × ( 1 + g ) / ( k – g )

If investors believe that P2 will be higher than P1, then a self-fulfilling cycle begins, repeats through P3 to Px.... 

In fact, the existence of an asset bubble when news about the price of an asset affects the economy, rather than the economy affecting the price of the asset.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.