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?
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.
Mir, Diego. “The bubble without any fizz.” The Economist, The Economist Newspaper, 7 Oct. 2017,
Kennon, Joshua. “Why Do Asset Prices Fall When Interest Rates Increase?” The Balance, 27 Aug.
Tabarrok, Alex . “Asset Prices and Interest Rates.” Marginal REVOLUTION, 27 Aug. 2013,