Finance Class paper on Asset Bubbles - Essay Example

Assets Bubbles “Bubbles in assets prices” de the economic phases in which the prices of assets expands rapidly to an unsustainable level after which the “bubble” burst resulting to a shrink in the price of assets (Kahneman et al. 27). Investors are speculative in nature, and they tend to invest the available resources on assets whose value they expect to increase in the future. The price escalates up to a certain level as more investors demand more of those assets resulting to inflation (Kahneman et al. 36). Such inflation is followed by a drastic decline in price that consequently results to the financial crisis.

The focus of this document it is to examine the cause of asset price bubbles using classic decision model. Classical decision-making model presumes that people objectively scrutinize the challenges affecting them and that they have full information of the situation (Kahneman et al. 53). By relying on that information, they can examine various alternatives of addressing those issues being aware of the repercussions of those alternatives before making an optimal resolution. This model when applied by investors it assumes that the investors assess various investments alternatives impartially having complete knowledge about the market value of the assets currently and in the future.

Since they make an objective analysis, there is usually high demand for assets as many people purchase them the future price will continue to rise indefinitely (Kahneman et al. 61). However, the situation reverses causing a sudden drop in value of those assets resulting to the economic crisis. The issue of the decision-making model involves bound and unbound problems and can be used to elaborate the occurrence of the reverse situation of the asset prices. Bound problems are issues within the control of decision makers while unbound problems are beyond the power of the decision makers.

For example, investors make predictions and commit their resources to the assets. (Kahneman et al. 94). However, the financial system such as the banking industry affects the market liquidity. The implication of the change in market liquidity is that at first the bank reduces lending rates attracting investors to take more money for investing in various assets and consequent increase in market liquidity (Kahneman et al. 124). As the demand for assets increases so is the increase in their values.

However, banks raise lending rates in the future due to excess liquidity resulting to decline in market liquidity (Kahneman et al. 175). The decreased flow of free money in the economy results to a reduction in demand for assets. Also, the banks start offering attractive interest rates to entice investors resulting to decline in consumption and further reduction in liquidity (Kahneman et al. 194). Therefore, the change in the market liquidity affects demand for assets over time resulting to “bubbles in price assets.

“In conclusion, the bubbles in assets prices result from an increase and subsequent decrease in value of the assets. According to classic decision model, investors make an accurate prediction based on full market information to commit their resources to various assets. However, since there are market conditions beyond the power of the investors such as change in capital liquidity the price of the assets falls drastically as the market liquidity condenses resulting to bubbles in the assets prices.

Works CitedKahneman, Daniel; Tversky, Amos and Slovic, Paul (Eds). “Judgment under Uncertainty: Heuristics and Biases.” (Cambridge University press, 1982): 1-520.