Animal Spirits, Financial Crises and Persistent Unemployment

Roger Farmer

No 8439, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper develops a rational expectations model with multiple equilibrium unemployment rates where the price of capital may be unbounded above. I argue that this property is an important feature of any rational-agent explanation of a financial crisis, since for the expansion phase of the crisis to be rational, investors must credibly believe that asset prices could keep increasing forever with positive probability. I explain the sudden crash in asset prices that precipitates a financial crisis as a large negative self-fulfilling shock to the expectation of the future price of capital. This shock causes a permanent reduction in wealth and consumption and a permanent increase in the unemployment rate. My work suggests that economic policies designed to reduce the volatility of asset market movements will significantly increase economic welfare.

Keywords: Animal spirits; Old-keynesian; Rational bubbles; Unemployment (search for similar items in EconPapers)
JEL-codes: E00 E12 E24 (search for similar items in EconPapers)
Date: 2011-06
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Citations: View citations in EconPapers (4)

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Working Paper: Animal Spirits, Financial Crises and Persistent Unemployment (2011)
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