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Rational Sentiments and Financial Frictions

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  • Paymon Khorrami
  • Fernando Mendo

Abstract

We provide a complete analysis of previously undocumented sunspot equilibria in a canonical dynamic economy with imperfect risk sharing. Methodologically, we employ stochastic stability theory to establish existence of this broad class of sunspot equilibria. Economically, self-fulfilling fluctuations are characterized by uncertainty shocks: changing beliefs about volatility trigger asset trades, which impacts productive efficiency and justifies the degree of uncertainty. We show how rational sentiment helps resolve two puzzles in the macro-finance literature: (i) financial crises emerge suddenly, featuring (quantitatively) hard-to-explain volatility spikes and asset-price declines; (ii) asset-price booms, with below-average risk premia, predict busts and financial crises.

Suggested Citation

  • Paymon Khorrami & Fernando Mendo, 2021. "Rational Sentiments and Financial Frictions," Working Papers Central Bank of Chile 928, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:928
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_928.pdf
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