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Bubbles and self-fulfilling crises

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  • Edouard Challe

    ()
    (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris IX - Paris Dauphine)

  • Xavier Ragot

    (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - École des Hautes Études en Sciences Sociales (EHESS) - École des Ponts ParisTech (ENPC) - École normale supérieure [ENS] - Paris)

Abstract

Financial crises are often associated with an endogenous credit reversal followed by a fall in asset prices and serious disruptions in the financial sector. To account for this sequence of events, this paper constructs a model where the excessive risk-taking of portfolio investors leads to a bubble in asset prices (in the spirit of Allen and Gale, "Bubbles and Crises", Economic Journal, 2000), and where the supply of credit to these investors is endogenous. We show that the interplay between the risk shifting problem and the endogeneity of credit may give rise multiple equilibria associated with different levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an inefficient liquidity dry-up at the intermediate date, a market crash, and widespread failures of borrowers. The possibility of multiple equilibria and self-fulfilling crises is showed to be related to the severity of the risk shifting problem in the economy.

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Bibliographic Info

Paper provided by HAL in its series PSE Working Papers with number halshs-00590568.

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Date of creation: Feb 2007
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Handle: RePEc:hal:psewpa:halshs-00590568

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Keywords: credit market imperfections ; self-fulfilling expectations ; financial crises;

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  1. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 103(3), pages 441-63, August.
  2. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "Currency crises and monetary policy in an economy with credit constraints," European Economic Review, Elsevier, Elsevier, vol. 45(7), pages 1121-1150.
  3. Challe, Edouard, 2004. "Sunspots and predictable asset returns," Economics Papers from University Paris Dauphine 123456789/2739, Paris Dauphine University.
  4. V. V. Chari & Patrick Kehoe, 1997. "Hot Money," NBER Working Papers 6007, National Bureau of Economic Research, Inc.
  5. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "A Corporate Balance Sheet Approach to Currency Crises," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3092, C.E.P.R. Discussion Papers.
  6. Velasco, Andres, 1996. "Fixed exchange rates: Credibility, flexibility and multiplicity," European Economic Review, Elsevier, Elsevier, vol. 40(3-5), pages 1023-1035, April.
  7. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1499-1528, November.
  8. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 35-54, November.
  9. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
  10. Graciela L. Kaminsky & Carmen M. Reinhart, 1996. "The twin crises: the causes of banking and balance-of-payments problems," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 544, Board of Governors of the Federal Reserve System (U.S.).
  11. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  13. Reinhart, Carmen & Kaminsky, Graciela, 1998. "Financial crises in Asia and Latin America: Then and now," MPRA Paper 13877, University Library of Munich, Germany.
  14. Chang, Roberto & Velasco, Andres, 2000. "Banks, debt maturity and financial crises," Journal of International Economics, Elsevier, Elsevier, vol. 51(1), pages 169-194, June.
  15. Graciela Laura Kaminsky, 1999. "Currency and Banking Crises," IMF Working Papers 99/178, International Monetary Fund.
  16. Edison, Hali J & Luangaram, Pongsak & Miller, Marcus, 2000. "Asset Bubbles, Leverage and 'Lifeboats': Elements of the East Asian Crisis," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 110(460), pages 309-34, January.
  17. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2006. "Bubbles and capital flow volatility: Causes and risk management," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(1), pages 35-53, January.
  18. Allen, Franklin & Gale, Douglas, 2000. "Bubbles and Crises," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 110(460), pages 236-55, January.
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Cited by:
  1. Edouard Challe & Benoit Monjon & Xavier Ragot, 2012. "Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System," Working Papers hal-00719952, HAL.
  2. Dubecq, S. & Mojon, B. & Ragot, X., 2009. "Fuzzy Capital Requirements, Risk-Shifting and the Risk Taking Channel of Monetary Policy," Working papers, Banque de France 254, Banque de France.
  3. Petr VALOUCH & Jaroslav SEDLÁCEK & Alois KONECNÝ, 2012. "Analysis of the Behavior Mergermarket in the Conditions the Financial Crisis," Economics and Applied Informatics, "Dunarea de Jos" University of Galati, Faculty of Economics and Business Administration, issue 1, pages 37-44.
  4. Sylvain Champonnois, 2011. "The limits of market discipline: proprietary trading and aggregate risk," 2011 Meeting Papers 1013, Society for Economic Dynamics.
  5. repec:hal:psewpa:hal-00719952 is not listed on IDEAS

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