Impact

Economic bubbles are generally considered to have a negative impact on the economy because they tend to cause misallocation of resources into non-optimal uses. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer (the wealth effect). Many observers quote the housing market in the United Kingdom, Australia, Spain and parts of the United States in recent times, as an example of this effect.[citation needed] When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes on asset price appreciation and take measures to curb high levels of speculative activity in financial assets.[citation needed] This is usually done by increasing the interest rate (that is, the cost of borrowing money).

 Possible causes

It has been variously suggested that bubbles may be rational,intrinsic,and contagious.To date, there is no widely accepted theory to explain their occurrence.

Puzzlingly, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends.Nevertheless, bubbles have been observed repeatedly in experimental markets, even with participants such as business students, managers, and professional traders. Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying, and insider trading.

While it is not clear what causes bubbles, there is evidence to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly.Further, it has been shown that bubbles appear even when speculation is not possible or when over-confidence is absent.