3.9.3. Feedback Models

The essence of a speculative bubble is the familiar feedback pattern—from price increases to increased investor enthusiasm to increased demand and, hence, to further price increase. The higher demand for the asset is generated by the public's memory of high past returns and optimism the high returns generate for the future (Shiller 2002).

When speculative prices go up, creating successes for some investors, this may attract public attention, promote word-of-mouth enthusiasm, and heighten expectations for further price increases. The talk attracts attention that justifies the price increases. This process, in turn, increases investor demand and thus generates another round of price increases. If the feedback is not interrupted, it may produce after many rounds a speculative "bubble", in which high expectations for further price increases support very high current prices. The high prices are ultimately not sustainable, since they are high only because of expectations of further price increases, and so the bubble eventually bursts, and prices come falling down.

The feedback that propelled that bubble carries the seeds of its own destruction, and the end of the bubble may be unrelated to news stories about fundamentals. The same feedback may also produce a negative bubble, downward price movements propelling further downward price movements, promoting word-of-mouth pessimism, until the market reaches an unsustainably low level (Shiller 2003).
