Rational Sentiments and Financial Frictions

Paymon Khorrami and Fernando Mendo

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: We provide a complete analysis of previously undocumented sunspot equilibria in a canonical dynamic economy with imperfect risk sharing. Methodologically, we employ stochastic stability theory to establish existence of this broad class of sunspot equilibria. Economically, self-fulfilling fluctuations are characterized by uncertainty shocks: changing beliefs about volatility trigger asset trades, which impacts productive efficiency and justifies the degree of uncertainty. We show how rational sentiment helps resolve two puzzles in the macro-finance literature: (i) financial crises emerge suddenly, featuring (quantitatively) hard-to-explain volatility spikes and asset-price declines; (ii) asset-price booms, with below-average risk premia, predict busts and financial crises.

Date: 2021-10
New Economics Papers: this item is included in nep-dge, nep-fdg and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chb:bcchwp:928

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