application/pdf 1061648 bytes The history of financial markets contains numerous episodes involving the spectacular rise of asset prices, followed by their collapse. From the Dutch Tulipomania in the 1600s to the housing prices that led to the global financial crisis of 2007–09, we have collected abundant empirical evidence of the dangers of asset price bubbles. The ability to predict—or at least mitigate the effects of—a speculative bubble became an essential question of financial and monetary economics. The role of monetary policy in bubble formation, on the one hand, and controlling and restricting bubbles, on the other hand, has been debated among academics, policymakers and practitioners. Most policymakers in the period before the global financial crisis would agree that monetary authority should control inflation and stabilize the output gap. Asset prices (and in particular prices of financial assets) were not regarded as contributors to inflation, nor were they considered crucial for monetary policy unless they are a threat to price or output stability. Notwithstanding one’s stance on the exact mechanisms of bubble formation and tools applied to disinflate them, there is a general unanimity that monetary policy does impact bubble formation. It is, however, debatable whether the higher short-term nominal interest rates may be helpful once a bubble is formed (Galí, 2014; Galí and Gambetti, 2015). Apart from the monetary policy concerns, other important factors may influence the emer gence and growth of a price bubble. Ackert et al. (2006) and Hussam et al. (2008) demonstrate that irregularity in dividends and the occurrence of shocks, for example, in the form of rapid growth in dividends, increase the size of a price bubble. Garber (1990) states that the main factor for bubbles to happen is investors’ perception of an increased probability of substantial returns. Harrison and Kreps (1978) develop a model where speculation and heterogeneous expectations are the key variables that lead to bubbles. This chapter uses an experiment to examine whether expansionary monetary policy combined with dividend irregularity makes the stock price bubbles more likely to occur. More specifically, we test the following hypotheses: (1) asset price bubbles are more likely to occur when (nominal) short-term interest rates are lower, and (2) asset price bubbles are more likely to occur when dividend payment patterns are more irregular. Our experiment simulates stock exchange trading under two ‘monetary policy’ regimes (expansionary and contractionary), represented by two interest rate treatments. Participants trade two types of shares, where one type pays more irregular dividends than the other. We use the Engle-Granger procedure to test for cointegration between the time series of simulated dividends and the corresponding prices obtained through a market-clearing system of the experimental exchange. Asset price bubbles are more likely to be detected when assets pay more irregular dividends. We also find that bubbles are more likely to occur under the contrac tionary monetary policy, that is, high nominal interest rates. Detailed analysis of participants’ portfolio structure provides a possible explanation for this seemingly counterintuitive result: speculation and high cash-to-asset (C/A) value ratios seem to be the main reasons for bubble formation, mainly through a ‘barbell’ strategy. Additionally, we calculate standard bubble measures used in experimental literature and introduce two more of our own. Most of these measures confirm our cointegration results. Several recent experimental studies investigate the link between monetary policy and price bubbles (see Fischbacher et al., 2013; Giusti et al., 2016; Fenig et al., 2018; Bao and Zong, 2019). These studies primarily focus on determining the effects of contractionary monetary policy on the disinflation of previously formed bubbles. We contribute to this stream of literature in two ways: first, by examining whether expansionary monetary policy facilitates the formation of asset price bubbles, and second, by investigating the role of uncertainties in the asset’s fundamental value. To the best of our knowledge, it is the first experimental study focusing on these two aspects simultaneously. The remainder of the chapter is organized as follows. Section 2 provides a review of related literature. Section 3 describes the experimental set-up. Results of the experiment are presented and discussed in Section 4. Concluding remarks are given in Section 5. The methodology applied to quantify the bubbles obtained from experimental prices is described in the Appendix. eng All rights reserved Handbook of Experimental Finance Monetary policy and cash flow irregularity as drivers of asset price bubbles : An experimental study Draganac, Dragana Božović, Miloš 2022 https://phaidrabg.bg.ac.rs/o:30328 doi:10.4337/9781800372337.00029 info:eu-repo/semantics/bookPart