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Bubbles and self-fulfilling crises

Listed author(s):
  • Edouard Challe

    ()

    (DRM - Dauphine Recherches en Management - Université Paris-Dauphine - CNRS - Centre National de la Recherche Scientifique)

  • Xavier Ragot

    (PSE - Paris-Jourdan Sciences Economiques - ENS Paris - École normale supérieure - Paris - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique)

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 the excessive risk-taking of portfolio investors leads to a bubble in asset prices (in the spirit of Allen and Gale, "Bubbles and Crises", Economic Journal, 2000), and where the supply of credit to these investors is endogenous. We show that the interplay between the risk shifting problem and the endogeneity of credit may give rise multiple equilibria associated with different levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an inefficient liquidity dry-up at the intermediate date, a market crash, and widespread failures of borrowers. The possibility of multiple equilibria and self-fulfilling crises is showed 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 PSE Working Papers with number halshs-00590568.

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Date of creation: Feb 2007
Handle: RePEc:hal:psewpa:halshs-00590568
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