Animal Spirits, Heterogeneous Expectations and the Amplification and Duration of Crises

Tiziana Assenza, William Brock and Cars Hommes

No 12-07, CeNDEF Working Papers from Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance

Abstract: We introduce a simple equilibrium model of a market for loans. Households lend to firms and form expectations about their loan default probability. Under heterogeneous expectations, with switching between forecasting strategies driven by reinforcement learning, even a small fraction of pessimistic traders has a large aggregate effect, causing a heterogeneous expectations risk premium, i.e. significantly higher contract rates for loans and significantly lower output. Our stylized model illustrates how animal spirits and heterogeneous expectations may lead to a confidence loss and to financial instability amplifying the magnitude of economic crises and slowing down recovery.

Date: 2012
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Journal Article: ANIMAL SPIRITS, HETEROGENEOUS EXPECTATIONS, AND THE AMPLIFICATION AND DURATION OF CRISES (2017)
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