Economics Assignment Paper on Response to Asset Pricing

Response to Asset Pricing

What, if anything, should be done about high asset prices?

Rising asset prices create a bull market. The high prices also create a bubble form of effect meaning the economy remains very fragile. Bubbles are known to burst at the slightest of unhealthy shocks. An economy with high asset prices could end up tumbling upon ‘contact’ with unfriendly market aspects as happened during the mid-2000s with the tech bubble and the late 1990s with the housing bubble (Mir n.p). The million dollar question, however, remains “What, if anything, should be done about high asset prices?” the most plausible answer to this question would be raising interest rates. High-interest rates would lead to asset prices falling. This result is achieved through the following two ways. Firstly, rising interest rates make the opportunity cost of the ‘risk-free’ rate more attractive. This translates to high earnings from both earnings and dividends yields causing stock prices to decline. Secondly, rising interest rates alter the cost of the capital structure of firms (Kennon n.p). Per the Gordon model, interest rates have an inverse relationship with asset prices because of the affect the present value of the stock prices. Is it a problem to be addressed by Central Bank, regulators (via additional capital), or should we just let “intelligent investors” deal with the issue?

The argument highlighted above point to raising interest rates as the corrective measure to the rising stock prices. This can achieve through the government’s monetary policy and foster behaviour of investments rather than saving among the masses. The latter is structurally harder since it depends on people’s preferences and conditions. However, the former is a viable option that can be utilized. Interest rate manipulation to achieve a desired macroeconomic outcome is a preserve of the Central Bank. Raising interest rates will work to discourage savings as the returns on investments will exceed the opportunity cost of saving (Tabarrok n.p). High-interest rates on stock also discount future earnings. These stocks end up yielding high gains in the future while their prices end up reducing. 

Works Cited

Mir, Diego. “The bubble without any fizz.” The Economist, The Economist Newspaper, 7 Oct. 2017,

www.economist.com/news/briefing/21729988-low-interest-rates-have-made-more-or-less-all-investments-expensive-bubble-without-any-fizz.

Kennon, Joshua. “Why Do Asset Prices Fall When Interest Rates Increase?” The Balance, 27 Aug.

            2016, www.thebalance.com/why-do-asset-prices-fall-when-interest-rates-increase-357150.

Tabarrok, Alex . “Asset Prices and Interest Rates.” Marginal REVOLUTION, 27 Aug. 2013,

            marginalrevolution.com/marginalrevolution/2013/08/asset-prices-and-interest-rates.html.