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Financial Fragility with Rational And Irrational Exuberance

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Author Info
Lagunoff, Roger
Schreft, Stacey L

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Abstract

This article formalizes investor rationality and irrationality, exuberance and apprehension, to consider the implications of belief formation for the fragility of an economy's financial structure. The model presented generates a financial structure with portfolio linkages that make it susceptible to contagious financial crises, despite the absence of coordination failures. Investors forecast the likelihood of loss from contagion and may shift preemptively to safer portfolios, breaking portfolio linkages in the process. The entire financial structure collapses when the last group of investors reallocates their portfolios. If some investors are irrationally exuberant, the financial structure remains intact longer. In fact, financial collapse occurs sooner when almost all investors are rationally exuberant than when they are irrationally exuberant. Additionally, a financial crisis initiated by real shocks is indistinguishable from one caused solely by the presence of rationally apprehensive investors in a fundamentally sound economy. Policies that make portfolio linkages more resilient can improve welfare.

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Publisher Info
Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 31 (1999)
Issue (Month): 3 (August)
Pages: 531-60
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Handle: RePEc:mcb:jmoncb:v:31:y:1999:i:3:p:531-60

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Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Roger Lagunoff & Stacey L. Schreft, 1998. "A Model of Financial Fragility," Game Theory and Information 9803001, EconWPA, revised 30 Apr 1998. [Downloadable!]
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Helmut Wagner & Wolfram Berger, 2004. "Globalization, Financial Volatility and Monetary Policy," Economic Change and Restructuring, Springer, vol. 31(2), pages 163-184, June. [Downloadable!] (restricted)
    Other versions:
  2. Jorge A. Chan-Lau & Iryna V. Ivaschenko, 2002. "Asian Flu or Wall Street Virus? Price and Volatility Spillovers of the Tech and Non-Tech Sectors in the United States and Asia," IMF Working Papers 02/154, International Monetary Fund. [Downloadable!]
  3. Eric Friedman & Simon Johnson & Adam Landsberg, 2001. "Large-Scale Synchrony, Global Interdependence and Contagion," Departmental Working Papers 200103, Rutgers University, Department of Economics. [Downloadable!]
  4. Scott Freeman, 2002. "Payments and Output," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 602-617, July. [Downloadable!] (restricted)
  5. Theodoros Diasakos, 2008. "Comparative Statics of General Equilibrium Asset Prices," Carlo Alberto Notebooks 72, Collegio Carlo Alberto. [Downloadable!]
  6. Terhi Jokipii & Brian Lucey, 2005. "CEE Banking Sector Co-Movement: Contagion or Interdependence?," The Institute for International Integration Studies Discussion Paper Series iiisdp077, IIIS. [Downloadable!]
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  7. Bullard, J. & Evans, G.W. & Honkapohja ,S., 2005. "Near-Rational Exuberance," Cambridge Working Papers in Economics 0546, Faculty of Economics, University of Cambridge. [Downloadable!]
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  8. Helmut Wagner & Wolfram Berger, 2003. "Financial Globalization and Monetary Policy," DNB Staff Reports (discontinued) 95, Netherlands Central Bank. [Downloadable!]
  9. Andreas Lehnert & Wayne Passmore, 1999. "Pricing systemic crises: monetary and fiscal policy when savers are uncertain," Finance and Economics Discussion Series 1999-33, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  10. David A. Marshall, 2001. "The crisis of 1998 and the role of the central bank," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 2-23. [Downloadable!]
  11. Eric J. Friedman & Simon Johnson & A.S. Landsberg, . "The Emergence of Correlations in Studies of Global Economic Inter-dependence and Contagion," Claremont Colleges Working Papers 2002-35, Claremont Colleges. [Downloadable!]
  12. James B. Bullard & George W. Evans & Seppo Honkapohja, 2007. "A model of near-rational exuberance," Working Papers 2007-009, Federal Reserve Bank of St. Louis. [Downloadable!]
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