Financial fragility with rational and irrational exuberance
AbstractThis 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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Bibliographic InfoPaper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number 99-01.
Date of creation: 1999
Date of revision:
Other versions of this item:
- Roger Lagunoff & Stacey L. Schreft, 1999. "Financial fragility with rational and irrational exuberance," Proceedings, Federal Reserve Bank of Cleveland, pages 531-567.
- Lagunoff, Roger & Schreft, Stacey L, 1999. "Financial Fragility with Rational And Irrational Exuberance," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 531-60, August.
- Roger Lagunoff & Stacey L. Schreft, 1999. "Financial Fragility with Rational and Irrational Exuberance," Macroeconomics 9904011, EconWPA.
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G1 - Financial Economics - - General Financial Markets
- C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
This paper has been announced in the following NEP Reports:
- NEP-ALL-1999-06-08 (All new papers)
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.:
- Roger D. Lagunoff & Stacey L. Schreft, 1998.
"A model of financial fragility,"
Research Working Paper
98-01, Federal Reserve Bank of Kansas City.
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