Monetary policy and cash flow irregularity as drivers of asset price bubbles: An experimental study

This chapter examines the impact of monetary policy and cash flow irregularity on bubble formation. We design an experimental setup with two levels of risk-free interest rate representing expansionary and contractionary monetary policy. Apart from borrowing and lending at the risk-free rate, participants could trade two types of stocks that differ only in parameters of the stochastic process that generates their dividends. For the first stock, dividends follow a simple diffusion, while for the second one, they follow a diffusion process with low-frequency Poisson jumps. We use the Engle-Granger procedure to test for cointegration between the time series of simulated dividends and the corresponding market-clearing prices obtained experimentally. We also calculate standard experimental bubble measures. The results based on cointegration tests indicate that bubbles are most likely to occur for the asset with more irregular dividends. On the other hand, experimental bubbles do not seem to be more likely under the expansionary monetary policy. Deviation measures corroborate these findings.