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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

Classical 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 intervention. Specifically, extrapolative expectations command tighter financial regulation, irrespective of the regulator's degree of non-rational extrapolation.

Suggested Citation

  • Antoine Camous & Alejandro Van der Ghote, 2023. "Evaluating the Financial Instability Hypothesis: A Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations," CRC TR 224 Discussion Paper Series crctr224_2023_431v2, University of Bonn and University of Mannheim, Germany, revised May 2024.
    • Handle: RePEc:bon:boncrc:crctr224_2023_431v2
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    References listed on IDEAS

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    1. Hyman P. Minsky, 1977. "The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to“Standard” Theory," Challenge, Taylor & Francis Journals, vol. 20(1), pages 20-27, March.
    2. Jean-Paul L’Huillier & Sanjay R Singh & Donghoon Yoo, 2024. "Incorporating Diagnostic Expectations into the New Keynesian Framework," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 91(5), pages 3013-3046.
    3. Gregory Phelan, 2016. "Financial Intermediation, Leverage, and Macroeconomic Instability," American Economic Journal: Macroeconomics, American Economic Association, vol. 8(4), pages 199-224, October.
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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G40 - Financial Economics - - Behavioral Finance - - - General

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