How is a financial bubble typically characterized?

A financial bubble is characterized by a rapid escalation of asset prices followed by a sharp decline. This phenomenon occurs when the prices of assets, such as stocks or real estate, increase to levels that are unsustainable, often driven by exuberance and speculation rather than fundamental value.

During the initial phase of a bubble, investors might perceive rising prices as a sign of a strong market, leading to increased demand and further price escalations. However, this growth is typically based on sentiment rather than intrinsic value. Eventually, reality sets in, and as investors begin to recognize that prices have become detached from fundamental values, panic can ensue, leading to rapid selling and a sharp decline in prices. This pattern creates the characteristic "boom and bust" cycle associated with financial bubbles.

Recognizing this cycle is crucial in understanding market dynamics and helps in identifying potential risks associated with investment decisions. This insight is important for anyone studying money and banking, as it illustrates how psychological factors can significantly influence financial markets and contribute to economic instability.