Causes of Financial Instability: Don’t Forget Finance

Dirk J. Bezemer

Economics Working Paper Archive from Levy Economics Institute

Abstract: Given the economy's complex behavior and sudden transitions as evidenced in the 2007–08 crisis, agent-based models are widely considered a promising alternative to current macroeconomic practice dominated by DSGE models. Their failure is commonly interpreted as a failure to incorporate heterogeneous interacting agents. This paper explains that complex behavior and sudden transitions also arise from the economy's financial structure as reflected in its balance sheets, not just from heterogeneous interacting agents. It introduces "flow-of-funds" and "accounting" models, which were preeminent in successful anticipations of the recent crisis. In illustration, a simple balance-sheet model of the economy is developed to demonstrate that nonlinear behavior and sudden transition may arise from the economy’s balance-sheet structure, even without any microfoundations. The paper concludes by discussing one recent example of combining flow-of-funds and agent-based models. This appears a promising avenue for future research.

Keywords: Credit Crisis; Finance; Complex Systems; DSGE; Agent-based Models; Stock-flow Consistent Models (search for similar items in EconPapers)
JEL-codes: B52 C63 E32 E37 E44 (search for similar items in EconPapers)
Date: 2011-04
New Economics Papers: this item is included in nep-hme and nep-pke
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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