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Evaluating the Financial Instability Hypothesis: a Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations

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  • Antoine Camous
  • Alejandro Van der Ghote

Abstract

Historical accounts of financial crises emphasize the joint contribution of extrapolative beliefs and leveraged risk-taking to financial instability. This paper proposes a simple macro-finance framework to evaluate these views. We find a novel interplay between non-rational extrapolation and investment risk-taking that amplifies financial instability relative to a rational expectation benchmark. Furthermore, the analysis provides guidance on the design of cyclical policy interventions. Specifically, relative to a rational expectations benchmark, extrapolative expectations command tighter financial regulation, irrespective of whether the regulator shares these expectations.

Suggested Citation

  • Antoine Camous & Alejandro Van der Ghote, 2025. "Evaluating the Financial Instability Hypothesis: a Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations," Working papers 1009, Banque de France.
    • Handle: RePEc:bfr:banfra:1009
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    References listed on IDEAS

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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy
    • G01 - Financial Economics - - General - - - Financial Crises

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