Animal Spirits, Financial Crises and Persistent Unemployment
AbstractThis paper develops a rational expectations model with multiple equilibrium unemployment rates and uses it to explain financial crises. In contrast to earlier work on this topic, the model has equilibria where asset prices are unbounded above. I argue that this is an important feature of any rational-agent explanation of a financial crisis, since for the expansion phase of the crisis to be rational, investors must credibly believe that asset prices could keep increasing forever with positive probability. I explain the sudden crash in asset prices that precipitates a financial crisis as a switch from a nonstationary equilibrium, to an alternative stationary equilibrium, with a high and inefficient unemployment rate. I also explain how variations in beliefs about future wealth cause movements in the stock market. These wealth movements are transmitted to the unemployment rate through variations in aggregate demand.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8439.
Date of creation: Jun 2011
Date of revision:
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Other versions of this item:
- Roger Farmer, 2011. "Animal Spirits, Financial Crises and Persistent Unemployment," NBER Working Papers 17137, National Bureau of Economic Research, Inc.
- E00 - Macroeconomics and Monetary Economics - - General - - - General
- E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
- E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution
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