Two key ingredients that caused the stock market bubble in 1920 and early 2000s are:
Herding is the human tendency to follow the crowd. It happens when individuals follow other individuals' behavior due to some fear or greed.
Leverage is the use of financial instrument or borrowed capital to increase the potential return of an investment. It is used in the financial market to earn more from the borrowed money or funds.
Federal reserve, commonly known as fed is the central bank of country U. The responsibility of this institutions is to develop and implement monetary policy for the country. It regulates the money supply and manipulates the interest rates as well.
When fed performs open market operations then they sell or buy bonds in the open market. If fed buys the bonds then the money fed paid gets deposited in banks and then first ripple happens which is the change in amount of reserve with the banks. Next ripple would be that bank would like to dispose off their excess reserves and to do so they give more
The extrapolative expectations refer to expectations that a trend will continue. Initially the market experiences a shock will lead to increase in price. This causes expectation of future price rise. This causes the demand curve to shift to right, which leads to further expectations and even expectations of multifold rise.
In the diagram, the initial equilibrium is at price P 0 where the quantity demanded and supplied is at Q 0. The demand curves shifts from D 0 to D 1 to D 2 as the expectations of price rise develops. Similarly, the prices rise from P 0 to P 1 to P 2. If the expectations are extrapolative, the people will expect that price rise will continue and demand curve shifts to right, which confirms that expectation. If we connect, the quantity demanded at each price it develops an effective upward sloping demand curve. In the diagram, the effective demand curve is labeled as bubble demand.