Cash Inflows and Bubbles in Asset Markets with Constant Fundamental Values

Previous experimental research on asset markets has reported that the level of cash available to traders does not affect asset prices when fundamentals follow a time trajectory that is constant over time. This contrasts with other research indicating that greater cash levels increase prices when fundamental values are decreasing over time. We report a new experiment in which we show that greater initial cash levels are indeed associated with higher prices when fundamental values are constant over time. Thus, high cash levels will lead to bubbles, if the cash is introduced before the market opens. Our results reconcile the two previous sets of findings. (JEL C90, D03, G02, G12) I. INTRODUCTION Smith, Suchanek, and Williams (1988) initiated the experimental study of markets for multiperiod, finitely lived assets. A considerable subsequent literature has consistently observed price bubbles in such markets. This consistency makes the Smith et al. paradigm a popular one for identifying and studying the factors that promote or dampen bubbles (see Palan 2013, for a survey of this literature). It is known that some key market parameters influence prices and the tendency for bubbles to form. Two of these parameters are (1) the time trajectory of fundamental values, and (2) the quantity of cash available for purchases compared to the quantity of assets available for sale. A number of studies in this literature have contrasted the behavior of different fundamental value time paths. The speed and effectiveness of price discovery, the tendency of market prices to track fundamentals, depend on the time path of the fundamental value trajectory (Breaban and Noussair 2015; Giusti, Jiang, and Xu 2012; Noussair and Powell 2010; Stockl, Huber, and Kirchler 2014). A trajectory that is constant over time generates closer adherence to fundamental values than a time path that is monotonically decreasing (Kirchler, Huber, and Stockl 2012; Noussair, Robin, and Ruffieux 2001; Smith, Van Boening, and Wellford 2000). (1) Another variable influencing market prices is the amount of liquidity traders have available for purchases. It is well established that in the case of decreasing fundamentals, the price level is affected by liquidity, as measured by cash endowment levels. Greater cash endowments lead to higher prices (Caginalp and Ilieva 2008; Caginalp, Porter, and Smith 1998, 2000, 2001; Haruvy and Noussair 2006). Cash and asset endowment levels are typically normalized into a measure of liquidity called the cash-to-asset (C/A) ratio (Caginalp, Porter, and Smith 2001). This is the ratio of cash in the economy, the total amount available for purchases of assets, to the value of all of the units of asset in the economy, evaluated at the fundamental value. In period t, the C/A ratio is given by [(C/A). sub.t] = [summation over (i)][c.sub. it]/[summation over (i)][q.sub. it][f.sub.t] where [(C/A). sub.t] is the C/A ratio in period t, [c.sub. it] is the cash available to trader i in period t, [q.sub. it] is the quantity of units that trader i holds in period t, and [f.sub.t] is the period t fundamental value. The ratio can be interpreted as the ratio of the largest long position to the largest short position an average trader can take, assuming that the market price is equal to the fundamental. To date, it has been shown that the cash asset ratio affects prices only for the case when fundamental values are decreasing. To our knowledge, only two studies have explored the effect of cash on prices when fundamentals are constant over time (Kirchler, Huber, and Stockl 2012, hereafter KHS, and Kirchler et al. 2015). In both of these studies, the additional cash is introduced after one or more periods of trading have elapsed, rather than before the market opens. KHS report that increases in cash endowments do not affect prices in the case of constant fundamental values. Because the authors interpret bubbles as a consequence of subject confusion about the experimental environment, they conclude that the constant fundamental value setting leads to less confusion on the part of subjects. …