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Financial Fragility with Rational and Irrational ExuberanceRoger D. Lagunoff |
Abstract This article formalizes investor rationality and irrationality, exuberance and
apprehension, to consider the implications of belief formation for the fragility of an
economy's financial structure. The model presented generates a financial structure with
portfolio linkages that make it susceptible to contagious financial crises, despite the
absence of coordination failures. Investors forecast the likelihood of loss from contagion
and may shift preemptively to safer portfolios, breaking portfolio linkages in the
process. The entire financial structure collapses when the last group of investors
reallocates their portfolios. If some investors are irrationally exuberant, the financial
structure remains intact longer. In fact, financial collapse occurs sooner when almost all
investors are rationally exuberant than when they are irrationally exuberant.
Additionally, a financial crisis initiated by real shocks is indistinguishable from one
caused solely by the presence of rationally apprehensive investors in a fundamentally
sound economy. Policies that make portfolio linkages more resilient can improve welfare. Roger D. Lagunoff is a professor of economics at Georgetown University. Stacey L.
Schreft is a senior economist at the Federal Reserve Bank of Kansas City. The authors
thank John Golob, Tom Humphrey, Will Roberds, discussants John Weinberg and Narayana
Kocherlakota, and the referees for their comments. The views expressed in this paper are
not necessarily those of the Federal Reserve Bank of Kansas City or the Federal Reserve
System.
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