Template-Type: ReDIF-Paper 1.0
Title: Evaluating the Financial Instability Hypothesis: A Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations
Author-Name: Antoine Camous
Author-Email: camous@uni-mannheim.de
Author-Name: Alejandro Van der Ghote
Author-Email: Alejandro.Van_der_Ghote@ecb.europa.es
Classification-JEL: E44, E60, E70, G20, G40
Keywords: financial frictions, financial amplifications, diagnostic expectations, financial regulation

Abstract: Classical accounts of financial crises emphasize the joint contribution of extrapolative
beliefs and leveraged risk-taking to financial instability. This paper proposes a
simple macro-finance framework to evaluate these views. We find a novel interplay
between non-rational extrapolation and investment risk-taking that amplifies financial
instability relative to a rational expectation benchmark. Furthermore, the analysis
provides guidance on the design of cyclical policy intervention. Specifically, extrapolative
expectations command tighter financial regulation, irrespective of the regulator's
degree of non-rational extrapolation.

Note: 
Length: 55
Creation-Date: 2023-05
Revision-Date: 2024-05
File-URL: https://www.crctr224.de/research/discussion-papers/archive/dp431
File-Format: application/pdf
Handle: RePEc:bon:boncrc:CRCTR224_2023_431v2