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An economic bubble (sometimes referred to as a "market bubble", a "financial bubble", or a "speculative mania") refers to a market condition in which the prices of commodities or asset classes increase to absurd or unsustainable levels (that no longer reflect utility of usage and purchasing power). It occurs when speculation in the underlying asset causes the price to increase, thus encouraging even more speculation. The bubble is usually followed by a sudden drop in prices, known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate chaotically, and become impossible to predict from supply and demand alone.

Economic bubbles are generally considered to have a negative impact on the economy because they cause misallocation of resources into non-optimal uses. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer (the Wealth Effect). Many observers quote the housing market in the United Kingdom, Australia, Spain and parts of the United States in recent times, as an example of this effect. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes on asset price appreciation and promptly take preemptive measures to curb high level of speculative activity in financial assets.

When the bubble occurs in equity markets, it is called a stock market bubble. It is usually very difficult to differentiate a stock market bubble from an ordinary bull market except in hindsight.

Causes

The cause of bubbles is often disputed although some experts believe that the cause of bubbles can be explained by the "greater fool's theory." The greater fool's theory explains the behavior of a perennially optimistic market participant (the fool) who buys an overvalued asset in anticipation of selling it to another rapacious speculator (the greater fool) at a much higher price. The bubbles continue as long as the fool can find another (greater) fool to pay up for the overvalued asset. The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price.

Read more at Wikipedia.org