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

Antoine Camous and Alejandro Van der Ghote

Working papers from Banque de France

Abstract: Historical 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 interventions. Specifically, relative to a rational expectations benchmark, extrapolative expectations command tighter financial regulation, irrespective of whether the regulator shares these expectations.

Keywords: Non-Rational Expectations; Financial Stability and Regulation (search for similar items in EconPapers)
JEL-codes: E44 E71 G01 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2025
New Economics Papers: this item is included in nep-cba and nep-his
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Persistent link: https://EconPapers.repec.org/RePEc:bfr:banfra:1009

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