Working Paper: CEPR ID: DP8439
Authors: Roger E. A. 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.
Keywords: animal spirits; Old-Keynesian; rational bubbles; unemployment
JEL Codes: E00; E12; E24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| animal spirits (E32) | asset prices (G19) |
| asset prices (G19) | unemployment rates (J64) |
| animal spirits (E32) | unemployment rates (J64) |
| belief function (D83) | asset prices (G19) |
| belief function (D83) | unemployment rates (J64) |