Animal Spirits, Heterogeneous Expectations and the Amplification and Duration of Crises

Abstract:     
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

working papers series