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Bubbles and Self-fulfilling Crises

  • Edouard Challe

    ()

    (CNRS-CEREG public)

  • Xavier Ragot

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 di¤erent levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an ine¢ cient 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 Society for Economic Dynamics in its series 2006 Meeting Papers with number 254.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:254
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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