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Animal Spirits, Financial Crises and Persistent Unemployment

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  • Roger Farmer

Abstract

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.

Suggested Citation

  • Roger Farmer, 2011. "Animal Spirits, Financial Crises and Persistent Unemployment," NBER Working Papers 17137, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17137
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    References listed on IDEAS

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    1. Alberto Martin & Jaume Ventura, 2012. "Economic Growth with Bubbles," American Economic Review, American Economic Association, vol. 102(6), pages 3033-3058, October.
    2. Carmen M. Reinhart & Kenneth S. Rogoff, 2014. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," Annals of Economics and Finance, Society for AEF, vol. 15(2), pages 1065-1188, November.
    3. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates," Introductory Chapters,in: This Time Is Different: Eight Centuries of Financial Folly Princeton University Press.
    4. Farmer, Roger E. A. & Plotnikov, Dmitry, 2012. "Does Fiscal Policy Matter? Blinder And Solow Revisited," Macroeconomic Dynamics, Cambridge University Press, vol. 16(S1), pages 149-166, April.
    5. Farmer, Roger E A, 2010. "Animal Spirits, Persistent Unemployment and the Belief Function," CEPR Discussion Papers 8100, C.E.P.R. Discussion Papers.
    6. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, January.
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    Cited by:

    1. Farmer, Roger E.A., 2016. "The Evolution Of Endogenous Business Cycles," Macroeconomic Dynamics, Cambridge University Press, vol. 20(02), pages 544-557, March.
    2. Lars Osberg, 2011. "Why Did Unemployment Disappear from Official Macro-Economic Policy Discourse in Canada?," New Directions for Intelligent Government in Canada: Papers in Honour of Ian Stewart,in: Fred Gorbet & Andrew Sharpe (ed.), New Directions for Intelligent Government in Canada: Papers in Honour of Ian Stewart, pages 127-162 Centre for the Study of Living Standards.

    More about this item

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity

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