A Theory of Aggregate Demand Fluctuations and Asset Bubbles

Abstract:     
We look at the financial markets as represented by a network of agents similar to bond percolation models in physics or epidemiology models. We aim to figure out how an agent based network model can cause perturbations that can cause failures of the traditional economic theory, specifically the AD-AS model of New Keynesian Theory. This model is utilized for its dual uses of having an inbuilt correction mechanism that is similar to what markets display and real world correlations in micro behaviour. We analyse the threshold conditions that result in boundaries beyond which an idea can spread throughout the network and look at the various factors that contribute towards such information percolation. It allows us a look into the micro-behaviour of agents involved in the markets and helps us look at a specific role of the market as a provider of feedback on actions taken. It further gives us a good insight into the roles needed to be played by policymakers and market regulators and gives a few modest proposals that could serve as a warning mechanism against future bubbles and Great Depressions. We look into such a system here to model how bubbles form in economic systems as a consequence of its current architecture and information transmission.

Number of Pages in PDF File: 29

Keywords: Financial Markets, Market Crash, Network Effects, New Keynesian Theory, Agent Based Model, Threshold Conditions, Spread of Ideas, Economic Networks, Aggregate Demand, Asset Bubbles

JEL Classification: G1, B22, C4, E12, E32

working papers series