Animal Spirits, Financial Crises and Persistent Unemployment

Roger Farmer

No 17137, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E0 E12 E24 (search for similar items in EconPapers)
Date: 2011-06
Note: EFG
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Published as “Animal Spirits, Persistent Unemployment and the Belief Function”, Chapter 7, in Rethinking Expectations: The Way Forward for Macroeconomics , Roman Frydman and Edmund Phelps eds, Princet on University Press, 2013
Published as Roger E.A. Farmer, 2013. "Animal Spirits, Financial Crises and Persistent Unemployment," The Economic Journal, vol 123(568), pages 317-340.

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