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Animal Spirits, Heterogeneous Expectations, And The Amplification And Duration Of Crises

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  • Tiziana Assenza
  • William A. Brock
  • Cars H. Hommes

Abstract

We introduce a simple equilibrium model of a market for loans. Households lend to firms and form expectations about their loan default probability. Under heterogeneous expectations, with switching between forecasting strategies driven by reinforcement learning, even a small fraction of pessimistic traders has a large aggregate effect, causing a heterogeneous expectations risk premium, i.e. significantly higher contract rates for loans and significantly lower output. Our stylized model illustrates how animal spirits and heterogeneous expectations may lead to a confidence loss and to financial instability amplifying the magnitude of economic crises and slowing down recovery.
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  • Tiziana Assenza & William A. Brock & Cars H. Hommes, 2017. "Animal Spirits, Heterogeneous Expectations, And The Amplification And Duration Of Crises," Economic Inquiry, Western Economic Association International, vol. 55(1), pages 542-564, January.
  • Handle: RePEc:bla:ecinqu:v:55:y:2017:i:1:p:542-564
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