Animal Spirits, Heterogeneous Expectations and the Emergence of Booms and Busts

Abstract

We introduce a simple equilibrium model of a market for loans, where households lend to firms based on heterogeneous expectations about their loan default probability. Agents select endogenously among heterogeneous expectation rules, based upon their relative performance. Due to strong nonlinearities, a small fraction of pessimistic traders already has a large aggregate effect, leading to a crisis characterized by high interest rates for loans and low output. Our stylized model illustrates how animal spirits and heterogeneous expectations and, in particular, how coordination on pessimistic expectations amplifies crises and slows down recovery

Reference

Tiziana Assenza, A. Brock, and C.H. Hommes, “Animal Spirits, Heterogeneous Expectations and the Emergence of Booms and Busts”, Economic Inquiry, Western Economic Association International, vol. 55, n. 1, 2017, pp. 542–564.