Evaluating the Financial Instability Hypothesis: A Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations

Antoine Camous and Alejandro Van der Ghote ()

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: Classical accounts of financial crises emphasize the joint contribution of extrapolative beliefs and leveraged risk-taking to financial instability. This paper proposes a simple macro-finance framework to evaluate these views. We find a novel interplay between non-rational extrapolation and investment risk-taking that amplifies financial instability relative to a rational expectation benchmark. Furthermore, the analysis provides guidance on the design of cyclical policy intervention. Specifically, extrapolative expectations command tighter financial regulation, irrespective of the regulator's degree of non-rational extrapolation.

Keywords: financial frictions; financial amplifications; diagnostic expectations; financial regulation (search for similar items in EconPapers)
JEL-codes: E44 E60 E70 G20 G40 (search for similar items in EconPapers)
Pages: 55
Date: 2023-05, Revised 2024-05
New Economics Papers: this item is included in nep-fdg and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:bon:boncrc:crctr224_2023_431v2

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