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Animal Spirits, Financial Crises and Persistent Unemployment

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  • Farmer, Roger E A

Abstract

This 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 Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8439.

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Date of creation: Jun 2011
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Handle: RePEc:cpr:ceprdp:8439

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Keywords: animal spirits; old-Keynesian; rational bubbles; unemployment;

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References

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  1. Martin, Alberto & Ventura, Jaume, 2010. "Economic Growth with Bubbles," CEPR Discussion Papers 7770, C.E.P.R. Discussion Papers.
  2. Farmer, Roger E A & Plotnikov, Dmitry, 2011. "Does Fiscal Policy Matter? Blinder and Solow Revisited," CEPR Discussion Papers 8189, C.E.P.R. Discussion Papers.
  3. Farmer, Roger E A, 2010. "Animal Spirits, Persistent Unemployment and the Belief Function," CEPR Discussion Papers 8100, C.E.P.R. Discussion Papers.
  4. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, December.
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Cited by:
  1. Farmer, Roger E A, 2012. "The Evolution of Endogenous Business Cycles," CEPR Discussion Papers 9080, C.E.P.R. Discussion Papers.
  2. Lars Osberg, 2011. "Why Did Unemployment Disappear from Official Macro-Economic Policy Discourse in Canada?," New Directions for Intelligent Government in Canada: Papers in Honour of Ian Stewart, in: Fred Gorbet & Andrew Sharpe (ed.), New Directions for Intelligent Government in Canada: Papers in Honour of Ian Stewart, pages 127-162 Centre for the Study of Living Standards.
  3. Roger Farmer, 2012. "The Stock Market Crash of 2008 Caused the Great Recession," 2012 Meeting Papers 145, Society for Economic Dynamics.

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