Financial cycles under diagnostic beliefs

Antoine Camous and Alejandro Van der Ghote

No 2659, Working Paper Series from European Central Bank

Abstract: Swift changes in investors' sentiment, such as the one triggered by COVID-19 global outbreak in March 2020, lead to financial tensions and asset price volatility. We study the interactions of behavioral and financial frictions in an environment with endogenous risk-taking and capital accumulation. Agents form diagnostic expectations about future stochastic outcomes: recent realizations of aggregate shocks are expected to persist. This behavioral friction gives rise to sentiment cycles with excessive investment and occasional safety traps. The interactions with financial frictions lead to an endogenous amplification of financial instability. We discuss implications for policy interventions. JEL Classification: E32, E44, E71

Keywords: diagnostic beliefs; financial cycles; macro-prudential policy (search for similar items in EconPapers)
Date: 2022-05
New Economics Papers: this item is included in nep-cba, nep-fdg and nep-mac
Note: 2828013
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20222659

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