The Financial Instability Hypothesis: A Stochastic Microfoundation Framework

28 Pages Posted: 25 Mar 2010  

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group

Corrado Di Guilmi

University of Technology Sydney (UTS) - School of Finance and Economics

Date Written: March 19, 2010

Abstract

This paper examines the dynamics of financial distress and in particular the mechanism of transmission of shocks from the financial sector to the real economy. The analysis is performed by representing the linkages between microeconomic financial variables and the aggregate performance of the economy by means of a microfounded model with firms that have heterogeneous capital structures. The model is solved both numerically and analytically, by means of a stochastic approximation that is able to replicate quite well the numerical solution. These methodologies, by overcoming the restrictions imposed by the traditional microfounded approach, enable us to provide some insights into the stabilization policies which may be effective in a financially fragile system.

Keywords: Financial fragility, complex dynamics, stochastic aggregation

JEL Classification: E12, E22, E44

Suggested Citation

Chiarella, Carl and Di Guilmi, Corrado, The Financial Instability Hypothesis: A Stochastic Microfoundation Framework (March 19, 2010). Available at SSRN: https://ssrn.com/abstract=1574615 or http://dx.doi.org/10.2139/ssrn.1574615

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group ( email )

PO Box 123
Broadway, NSW 2007
Australia
+61 2 9514 7719 (Phone)
+61 2 9514 7711 (Fax)

HOME PAGE: http://www.business.uts.edu.au/finance/

Corrado Di Guilmi (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

PO box 123
Broadway
Sydney, 2007
Australia

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