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Animal Spirits, Financial Crises and Persistent Unemployment

  • Farmer, Roger E A

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8439.

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Date of creation: Jun 2011
Date of revision:
Handle: RePEc:cpr:ceprdp:8439
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References listed on IDEAS
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  1. Jaume Ventura and Alberto Martín, 2010. "Economic Growth with Bubbles," Working Papers 445, Barcelona Graduate School of Economics.
  2. Roger E.A. Farmer & Dmitry Plotnikov, 2010. "Does Fiscal Policy Matter? Blinder and Solow Revisited," NBER Working Papers 16644, National Bureau of Economic Research, Inc.
  3. Reinhart, Carmen, 2009. "The Second Great Contraction," MPRA Paper 21485, University Library of Munich, Germany.
  4. Farmer, Roger E A, 2010. "Animal Spirits, Persistent Unemployment and the Belief Function," CEPR Discussion Papers 8100, C.E.P.R. Discussion Papers.
  5. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, June.
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