Animal Spirits, Heterogeneous Expectations and the Amplification and Duration of Crises
Catholic University of Milan; University of Amsterdam - CeNDEF
C. H. Hommes
University of Amsterdam; CeNDEF; Tinbergen Institute
William A. Brock
University of Wisconsin, Madison - Department of Economics ; University of Missouri at Columbia - Department of Economics
June 30, 2012
We introduce a simple equilibrium model of a market for loans. Households lend to firms and form expectations about their loan default probability. Under heterogeneous expectations, with switching between forecasting strategies driven by reinforcement learning, even a small fraction of pessimistic traders has a large aggregate effect, causing a heterogeneous expectations risk premium, i.e. significantly higher contract rates for loans and significantly lower output. Our stylized model illustrates how animal spirits and heterogeneous expectations may lead to a confidence loss and to financial instability amplifying the magnitude of economic crises and slowing down recovery.
Number of Pages in PDF File: 39
Keywords: Heterogeneous Expectations, Crises, Animal Spirits
JEL Classification: E32, D83, D84
Date posted: July 4, 2012 ; Last revised: July 5, 2012
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