Financial fragility with rational and irrational exuberance

Roger Lagunoff and Stacey Schreft

No 99-01, Research Working Paper from Federal Reserve Bank of Kansas City

Abstract: This article formalizes investor rationality and irrationality, exuberance and apprehension, to consider the implications of belief formation for the fragility of an economy's financial structure. The model presented generates a financial structure with portfolio linkages that make it susceptible to contagious financial crises, despite the absence of coordination failures. Investors forecast the likelihood of loss from contagion and may shift preemptively to safer portfolios, breaking portfolio linkages in the process. The entire financial structure collapses when the last group of investors reallocates their portfolios. If some investors are irrationally exuberant, the financial structure remains intact longer. In fact, financial collapse occurs sooner when almost all investors are rationally exuberant than when they are irrationally exuberant. Additionally, a financial crisis initiated by real shocks is indistinguishable from one caused solely by the presence of rationally apprehensive investors in a fundamentally sound economy. Policies that make portfolio linkages more resilient can improve welfare.

Keywords: Financial; markets (search for similar items in EconPapers)
Date: 1999
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Citations: View citations in EconPapers (24)

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Related works:
Journal Article: Financial fragility with rational and irrational exuberance (1999)
Journal Article: Financial Fragility with Rational And Irrational Exuberance (1999)
Working Paper: Financial Fragility with Rational and Irrational Exuberance (1999)
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