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Bubbles and Self-Fulfilling Crises

Listed author(s):
  • Edouard Challe

    (Centre de recherche de la Banque de France - Banque de France, Ecole Polytechnique [Palaiseau])

  • Xavier Ragot

    (Centre de recherche de la Banque de France - Banque de France, PSE - Paris School of Economics, PSE - Paris-Jourdan Sciences Economiques - CNRS - Centre National de la Recherche Scientifique - ENPC - École des Ponts ParisTech - EHESS - École des hautes études en sciences sociales - INRA - Institut National de la Recherche Agronomique - ENS Paris - École normale supérieure - Paris)

Financial crises are often associated with an endogenous credit reversal followed by a fall in asset prices and serious disruptions in the financial sector. To account for this sequence of events, this paper constructs a model where excessive risk-taking by investors leads to a bubble in asset prices, and where the supply of credit to these investors is endogenous. We show that the interplay between excessive risk-taking and the endogeneity of credit may give rise to multiple equilibria associated with different levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an inefficient liquidity dry-up, a market crash, and widespread failures by borrowers. The possibility of multiple equilibria and self-fulfilling crises is shown to be related to the severity of the risk-shifting problem in the economy.

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Paper provided by HAL in its series Post-Print with number halshs-00654655.

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Date of creation: May 2011
Publication status: Published in B.E. Journal of Macroeconomics, 2011, 11 (1), pp.article 8. <10.2202/1935-1690.2064>
Handle: RePEc:hal:journl:halshs-00654655
DOI: 10.2202/1935-1690.2064
Note: View the original document on HAL open archive server: https://halshs.archives-ouvertes.fr/halshs-00654655
Contact details of provider: Web page: https://hal.archives-ouvertes.fr/

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