ABSTRACT
Allowing that anticipations are formed rationally, economic literature provides at least four possible scenarios that would account for a price bubble in an asset market. The economic interpretation of rational expectations following Muth (1961) is that the anticipation by agents of actual price movements will be expectations capable of being expressed mathematically, that are conditional on an information set likely to include structural knowledge of a particular economic model of the market. Flood and Garber (1980, p. 746) point out that where the expected rate of market price change is an influence on the current market price it is difficult to find a determinate estimate of agents’ expectations because solutions for both market price and the expected rate of price change are required. Because the assumption of rational expectations eliminates the possibility that agents might make systematic prediction errors, it is probable that there will be positive relationships between price and its expected rate of change and between price and its actual rate of change. Flood and Garber argue that in these circumstances the arbitrary, self-fulfilling expectation of price changes may cause a price bubble by driving actual price changes independently of market fundamentals.
