Eliminating Laboratory Asset Bubbles by Paying Interest on Cash

Giusti, Giovanni and Jiang, Janet Hua and Xu, Yiping (2012): Eliminating Laboratory Asset Bubbles by Paying Interest on Cash.

Abstract

The seminal work of Smith Suchanek and Williams (1988) finds price bubbles are frequently observed in an experimental asset market where a single asset with a finite lifetime is traded. Ever since, many studies have been carried out to understand the reason why bubbles occur in such an environment and to find mechanisms to eliminate bubbles.In this paper, we introduce an interest-bearing savings account to the experimental asset market. We find bubbles disappear with high interest rates. The effect of the interest rate potentially works in two ways. First, the savings account increases the opportunity cost of buying shares, which in turn, reduces the incentive to speculate and alleviates the “active participation” problem as raised in Lei, Noussair and Plott (2001). Second, fixing the dividend process and terminal value of the asset, the time trend of the fundamental value of the asset becomes positive with a high interest rate. An increasing fundamental value is more compatible with subjects’ perception that asset prices tend to be flat or increasing in the long run. Therefore, subjects are more likely to follow the fundamental value when they trade and over-pricing is lessened. To disentangle the effects through the two channels, we run a second set of experiments with high interest rate but a lower terminal value to induce the fundamental value of the asset to decrease over time. Bubbles reappear in these sessions, which suggests the time path of the fundamental value is more important for reducing bubbles.

• Item Type: MPRA Paper
• Language: English
• Keywords: Asset Bubbles; Experimental Economics
• Subjects: C - Mathematical and Quantitative Methods > C9 - Design of Experiments > C90 - General; G - Financial Economics > G1 - General Financial Markets > G10 - General

References

Bostian, AJ. A., Goeree J. K. , and Charles A. Holt (2006), "Price bubbles in asset market experiments with a flat fundamental value," Discussion paper, University of Virginia.

Bostian, AJ. A. and Charles A. Holt (2009), "Price Bubbles with Discounting: A Web-Based Classroom Experiment", Journal of Economic Education, 40, 27-37.

Brunnermeier, Markus K. (2009), "Bubbles," in The New Palgrave Dictionary of Economics(2nd edition), edited by Steven Durlauf and Lawrence Blume.

Duffy, John, and Utku Ünver (2006), "Asset Price Bubbles and Crashes with Near-zerointelligence Traders," Economic Theory, 27, 537-63.

Dufwenberg, Martin, Lingqvist, Tobias and Evan Moore (2005), "Bubbles and Experience:an Experiment," American Economic Review, 95, 1731-1737.

Fischbacher, Urs (2007), "Z-Tree: Zurich Toolbox for Ready-made Economic Experiments," Experimental Economics, 10(2), 171-178.

Fisher, Eric O’N, and Frank Kelly (2000), "Experimental Foreign Exchange Markets," Pacific Economic Review, 5, 365-387.

Kirchler, Michael; Huber, Juergen and Stöckl, Thomas (forthcoming), "Thar She Bursts - Reducing Confusion Reduces Bubbles," American Economic Review.

Hussam, Reshmaan N., Porter, David and Vernon Smith (2008), "Thar She Blows: Can Bubbles Be Rekindled with Experienced Subjects?", American Economic Review, 98, 924- 937.

King, Ronald, Smith, Vernon, Williams, Arlington, and Mark Van Boening (1993), "The Robustness of Bubbles and Crashes in Experimental Stock Markets," in Nonlinear Dynamics and Evolutionary Economics, ed. by I. Prigogine, R. Day, and P. Chen, Oxford: Oxford University Press.

Lei, Vivian, Noussair, Charles N., and Charles R. Plott (2001), "Nonspeculative bubbles in experimental asset markets: lack of common knowledge of rationality vs. actual irrationality," Econometrica, 831-859.

Lei, Vivian and Filip Vesely (2009);"Market Efficiency, Evidence from a No-bubble Asset Market Experiment," Pacific Economic Review, 14, 246-258.

Lugovskyy, Vololymyr, Puzzelo, Daniela, and Steven Tucker (2010), "An Experimental Study of Bubble Formation in Asset Markets Using the Tâtonnement Trading Institution," working paper.

Noussair, Charles and Owen Powell (2010), " Peaks and valleys: Price discovery in experimental asset markets with non-monotonic fundamentals," Journal of Economic Studies,37(2), 152-180.

Noussair, Charles, Robin, Stephane, and Bernard Ruffieux (2001), "Price Bubbles in Laboratory Asset Markets with Constant Fundamental Values," Experimental Economics, 4, 87- 105.

Oechssler, Jörg (2010), "Searching beyond the lamppost: Let’s focus on economically relevant questions,"Journal of Economic Behavior and Organization, 73, 65-67.

Porter, David, and Vernon Smith (1995), "Futures contracting and dividend uncertainty in experimental asset markets," Journal of Business, 68, 509-541.

Smith, Vernon, Suchanek, Gerry, and Arlington Williams (1988) "Bubbles, Crashes and Endogenous Expectations in Experimental Spot Asset Markets," Econometrica, 56, 1119- 1151.

Smith, Vernon, Van Boening, Mark, and CharissaWellford (2000), "Dividend Timing and Behavior in Laboratory Asset Markets," Economic Theory, 16, 567-583.

Smith, Vernon (2010), "Theory and experiment: what are the questions?,"Journal of Economic Behavior and Organization, 73, 3-15.

Stockl, Thomas, Huber, Jurgen, and Michael Kirchler (2010), "Bubble Measures in Experimental Asset Markets," Experimental Economics, 13, 284-298.

Van Boening, Mark, Williams, Arlington, and Shawn La Master (1993), "Price Bubbles and Crashes in Experimental Call Markets," Economics Letters, 41, 179-185.