Bubbles and self fullfilling crisis

Edouard Challe , Xavier Ragot (1)

1 ECON - Département d'économie (Sciences Po)

Financial crises are often associated with an endogenous credit reversal followed by a fall in asset prices and serious disruptions in the financial sector. To account for this sequence of events, this paper constructs a model where excessive risk-taking by investorsleads to a bubble in asset prices, and where the supply of credit to these investors is endogenous. We show that the interplay between excessive risk-taking and the endogeneity of credit may give rise to multiple equilibria associated with different levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an inefficient liquidity dry-up, a market crash, and widespread failures by borrowers. The possibility of multipleequilibria and self-fulfilling crises is shown to be related to the severity of the risk-shifting problem in the economy

Mots clés: Credit market imperfections; Self fullfilling expectaions; Financial crisis

Domaines: Economies et finances

Edouard Challe, Xavier Ragot. Bubbles and self fullfilling crisis. 2005. ⟨hal-03462262⟩