Speculation and Price Indeterminacy in Financial Markets: An Experimental Study

Abstract

To explore how speculative trading influences prices in financial markets, we conduct a laboratory market experiment with speculating investors (who do not collect dividends and trade only for capital gains) and dividend-collecting investors. Moreover, we operate markets at two different levels of money supply. We find that in phases with only speculating investors present (i) price deviations from fundamentals are larger; (ii) prices are more volatile; (iii) mispricing increases with the number of transfers until maturity; and (iv) speculative trading pushes prices upward (downward) when the supply of money is high (low). These results suggest that controlling the money supply can help to stabilize asset prices.

Keywords: Experimental finance, Speculation, Money supply, Rational expectations, Price efficiency, Price bubbles, Overlapping generations, Backward and forward induction

JEL Classification: C91, G11, G12