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Animal Spirits, Financial Crises and Persistent Unemployment

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  • Roger Farmer

Abstract

This paper develops a rational expectations model with multiple equilibrium unemployment rates where the price of capital may be unbounded above. I argue that this property 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 large negative self-fulfilling shock to the expectation of the future price of capital. This shock causes a permanent reduction in wealth and consumption and a permanent increase in the unemployment rate. My work suggests that economic policies designed to reduce the volatility of asset market movements will significantly increase economic welfare.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17137.

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Date of creation: Jun 2011
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Publication status: published as “Animal Spirits, Persistent Unemployment and the Belief Function”, Chapter 7, in Rethinking Expectations: The Way Forward for Macroeconomics , Roman Frydman and Edmund Phelps eds, Princet on University Press, 2013
Handle: RePEc:nbr:nberwo:17137

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  1. Alberto Martin, 2010. "Economic Growth with Bubbles," 2010 Meeting Papers, Society for Economic Dynamics 788, Society for Economic Dynamics.
  2. Roger Farmer & Dmitry Plotnikov, 2012. "Does Fiscal Policy Matter? Blinder and Solow Revisited," 2012 Meeting Papers, Society for Economic Dynamics 73, Society for Economic Dynamics.
  3. Roger E.A. Farmer, 2010. "Animal Spirits, Persistent Unemployment and the Belief Function," NBER Working Papers 16522, National Bureau of Economic Research, Inc.
  4. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, The MIT Press, edition 2, volume 1, number 0262062038, December.
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Cited by:
  1. Roger E.A. Farmer, 2012. "The Evolution of Endogenous Business Cycles," NBER Working Papers 18284, National Bureau of Economic Research, Inc.
  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, Centre for the Study of Living Standards, 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, Society for Economic Dynamics 145, Society for Economic Dynamics.

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