Must-Read: Roger Farmer (2013): Animal Spirits, Financial Crises, and Persistent Unemployment
Must-Read: (2013): Animal Spirits, Financial Crises, and Persistent Unemployment: “This article uses a rational expectations model with multiple equilibrium unemployment rates…
…to explain financial crises. The model has equilibria where asset prices are unbounded above. I argue that this 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 shock to expectations that leads to a permanent increase in the unemployment rate.