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Animal Spirits, Financial Crises and Persistent Unemployment

  • Roger Farmer

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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File URL: http://www.nber.org/papers/w17137.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17137.

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Date of creation: Jun 2011
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Publication status: published as “Animal Spirits, Persistent Unemployment and the Belief Function”, Chapter 7, in Rethinking Expectations: The Way Forward for Macroeconomics , Roman Frydman and Edmund Phelps eds, Princet on University Press, 2013
Handle: RePEc:nbr:nberwo:17137
Note: EFG
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  1. Alberto Martin & Jaume Ventura, 2003. "Economic growth with bubbles," Economics Working Papers 848, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2011.
  2. Farmer, Roger E A & Plotnikov, Dmitry, 2011. "Does Fiscal Policy Matter? Blinder and Solow Revisited," CEPR Discussion Papers 8189, C.E.P.R. Discussion Papers.
  3. Farmer, Roger E A, 2010. "Animal Spirits, Persistent Unemployment and the Belief Function," CEPR Discussion Papers 8100, C.E.P.R. Discussion Papers.
  4. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973, March.
  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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