Bubbles and Self-fulfilling Crises

Edouard Challe and Xavier Ragot

No 254, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: Financial crises are often associated with an endogenous credit reversal followed by a fall in asset prices and serious disruptions in the financial sector. To account for this sequence of events, this paper constructs a model where the excessive risk-taking of portfolio investors leads to a bubble in asset prices (in the spirit of Allen and Gale, 'Bubbles and Crises', Economic Journal, 2000), and where the supply of credit to these investors is endogenous. We show that the interplay between the risk shifting problem and the endogeneity of credit may give rise multiple equilibria associated with di¤erent levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an ine¢ cient liquidity dry-up at the intermediate date, a market crash, and widespread failures of borrowers. The possibility of multiple equilibria and self-fulfilling crises is showed to be related to the severity of the risk shifting problem in the economy

Keywords: Credit market imperfections; self-fulfilling expectations; financial crises. (search for similar items in EconPapers)
JEL-codes: G12 G33 (search for similar items in EconPapers)
Date: 2006
New Economics Papers: this item is included in nep-ban
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Related works:
Journal Article: Bubbles and Self-Fulfilling Crises (2011)
Working Paper: Bubbles and Self-Fulfilling Crises (2011)
Working Paper: Bubbles and Self-Fulfilling Crises (2011)
Working Paper: Bubbles and self-fulfilling crises (2007)
Working Paper: Bubbles and self-fulfilling crises (2007)
Working Paper: Bubbles and self fullfilling crisis (2005)
Working Paper: Bubbles and self fullfilling crisis (2005)
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