Teaching financial crises: A leverage experiment

Abstract College students often struggle to understand the prevalence of asset price bubbles and the difficulty of timing asset purchases and sales. Even economics students are consistently surprised when bubbles burst. These breaks can have real macroeconomic effects, particularly when the price surge is fueled by leverage. This paper describes a web‐based class experiment designed to teach students about how leverage increases the magnitude and ramifications of bubbles. Participant students choose between investing in an asset with risky returns (which can be leveraged) and a safe asset that pays interest. These markets consistently generate prices well above fundamental values. Furthermore, the price bubbles are generally more extreme when credit is easier (low cash down‐payment requirements), when exogenous incomes are higher, and when the duration of the experiment is longer. The class results can be used to draw parallels to examples of leveraged bubbles and their consequences, such as the 2007–2009 Great Recession. This experiment is available for instructors online and is particularly well suited for Principles of Macroeconomics, Money and Banking, and Behavioral Finance classes.