A key feature of our model is that it generates contagion without the release of public news or other information. In this paper we present a rational expectations, nancial model of contagion. In such cases, it is straightforward to move from the recursive formulation of decision problems to the definition of a recursive equilibrium that expresses prices as a function of a small. This study examines how heterogeneity of private information may induce financial contagion. April 19, 2001 forthcoming in the journal of finance abstract we develop a multiple asset rational expectations model of asset prices to explain nancial market contagion. Lecture notes 4 the monetary approach under rational expectations. This would make rumors r of rational expectations when applied to financial markets, is known as. We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Rational contagion and the globalization of securities. The rational expectations theory is a concept and modeling technique that is used widely in macroeconomics.
Such phenomenon is explained by models of expectations formation in the context of. In economics, a theory stating that economic actors make decisions based on their expectations for the future, which are based on their observations and past experiences. A rational expectations equilibrium model of crises, contagion, and confusion kathy yuan. Market participants, when hit with a liquidity shock, would benefit most from selling in highly liquid markets since this lowers the impact of their sell orders on prices. A rational expectations model of financial contagion kodres. A rational expectations model of financial contagion by laura e. A rational expectations model of financial contagion created date. Theory of rational expectation theories macroeconomics. In economics, rational expectations are model consistent expectations, in that agents inside the model are assumed to know the model and on average take the model s predictions as valid. Muth of indiana university first proposed the theory of rational expectations in the early period of 1960s.
Section vi relates the properties of the model to the patterns of contagion in recent crises. The most important implication of the rational expectations model on economics during the last decade or so has been that aggregate demand management designed to lower unemployment will always be ineffective. A rational expectations model of financial contagion by. The properties of the model for contagion are explored in sections ii through v. The theory posits that individuals base their decisions on three primary factors. The rational expectations hypothesis is that the expectations relevant to economic outcomes are appropriately proxied by the forecasts derived from the economists model. Similarity transformations has the property that they do not change the eigenvalues of a matrix, so t. The pattern and severity of financial contagion depends on markets sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. When fundamentals and common shocks do not fully explain the relationship among countries, spillover effects are attributed to herding behavior, either rational or irrational. A rational expectations model of financial contagion 771 nel is not wholly satisfying for a different reason. No doubt, the theory of rational expectations is a major breakthrough in macroeconomics. In this paper, we present a model of financial contagion which formalizes this latter. In these markets, people with better forecasts of the future get rich the application of the theory of rational expectations to financial markets where it is called the efficient market hypothesis is thus particularly useful.
Kodres and matthew pritskery december 16, 1998 abstract we develop a multiple asset rational expectations model of asset prices to study the determinants of nancial market contagion, and to provide an explanation for the pattern of contagion during the asian nancial crisis. A rational expectations model of financial contagion, journal of finance, 57. Abstract we develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Using a model of multiasset trading in which the three main channels of contagion through financial linkages in the literature correlated information, correlated liquidity, and portfolio rebalancing are ruled out by construction, i show that financial contagion can still be an equilibrium outcome.
Request pdf a rational expectation model of financial contagion we develop a multiple asset rational expectations model of asset prices to explain. A rational expectations model of financial contagion federal. The incentives for equating expectations with optimal forecasts are especially strong in financial markets. The model of contagion presented in this paper is a multiple asset, noisy rational expectations. Rational expectations hypothesis financial definition of. A rational expectations model of financial contagion by laura. B financial market contagion recent research has greatly improved the understanding of financial contagion. He success or failure of any course of action often depends on the ability to anticipate events that have not yet occurred, or that have occurred but ate not yet known. Financial contagion and attention allocation university of toronto. When agents are hit by a shock in one market, they need to rebalance their portfolio of assets. A rational expectations model of financial contagion core. In particular, the model explains the characteristics. A rational expectations model of financial contagion.
This paper investigates the informational role of prices in segmented markets which are shocked by a kind of common sentiment resulting from financial contagion. For any square matrix w, w 1awis a so called similarity transformation of a. The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences. Rational expectations an overview sciencedirect topics. This would make rumors r rational expectations model of financial contagion laurae. Feds working paper 199848, the federal reserve board. Pritsker 2002, a rational expectations model of financial contagion, journal of finance 57 2, pp. A rational expectations model of financial contagion laura e. However, the idea was not widely used in macroeconomics until the new classical revolution of the early 1970s, popularized by robert lucas and t. A consistency condition under rational expectations implies erik r, since r is an expectation based on free information and the p. A rational expectations model of financial contagion finance and economics discussion series kodres, laura e on. Investors forecast the likelihood of loss from contagion and may shift preemptively to safer portfolios, breaking portfolio linkages in the process. Read this article to learn about the seven major implications and challenges of rational expectations.
Furthermore, it may not in general be possible to infer empirically whether it is the model. The idea of rational expectations was first discussed by john f. Financial fragility with rational and irrational exuberance. A rational expectations model of financial contagion laurae. A rational expectations model of financial contagion, journal of finance 57 2, pp. The next section presents our general model of asset prices. We develop a multiple asset rational expectations model of asset prices to study the determinants of financial market contagion, and to provide an explanation.
Finance and economics discussion series feds federal reserve. Their work presents a further mechanism of contagion. He success or failure of any course of action often depends on the ability to anticipate events that have not yet occurred, or that have occurred but ate. Kodres and others published a rational expectations model of financial contagion find, read and cite all the research you need on researchgate. Rational expectations theory definition investopedia. Using our model we provide a potential explanation for the uneven pattern of nancial market contagion. Rational expectations ensure internal consistency in models involving uncertainty. A rational expectations model of financial contagion finance and economics discussion series. Asymmetric price movements and borrowing constraints. A rational expectation model of financial contagion request pdf. In economics, rational expectations are modelconsistent expectations, in that agents inside the model are assumed to know the model and on average take the models predictions as valid. Consistent with empirical observations, the model finds.
Although themodel allows contagion through several chan. This common sentiment bridges the connection between prices learned by rational traders and thus can weaken the uncertainty from noise shock. A rational expectation model of financial contagion. We develop a multiple asset rational expectations model of asset prices to study the determinants of financial market contagion, and to provide an explanation for the pattern of contagion during the asian financial crisis. Model of financial contagion, journal of finance 57. Rational expectations and the theory of price movements. Better way to regard rational expectations as an omnipresent modeling techniques which is widely used towards economics rather than thinking rational expectations as a school of economic thought. No 199848, finance and economics discussion series from board of governors of the federal reserve system u. Our findings show that the pattern and severity of financial contagion depends on the size of markets sensitivities to common macroeconomic. Rational expectations theory withdrew freedom from savages 1954 decision theory by imposing equality between agents subjective probabilities and the probabilities emerging from the economic model containing those agents.
Although the model allows contagion through several channels, our focus is on contagion through crossmarket rebalancing. Oct 16, 2019 this paper investigates the informational role of prices in segmented markets which are shocked by a kind of common sentiment resulting from financial contagion. The current debate on financial contagion is motivated by a number of policy questions. A rational expectations model of financial contagion finance. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios exposures to shared macroeconomic risks. Although the model allows contagion through several channels, our focus is on contagion through cross. The authors find that there exist comovement effect and crowdingout effect in information.
A rational expectations model of financial contagion pdf laura e. We develop a multiple asset rational expectations model of asset prices to study the determinants of financial market contagion, and to provide an explanation f. Macroeconomic analysis without the rational expectations. Solving linear rational expectations models 3 where tis at least upper block triangular t 2 4 t 11 t 12 0 t 22 3 5 1. Pdf a rational expectations model of financial contagion. The stock market, the theory of rational expectations. Contagion is commonly referred to being the result of herding behaviour. The model presented generates a financial structure with portfolio linkages that make it susceptible to contagious financial crises, despite the absence of coordination failures. To obtain consistency within a model, the predictions of future values of economically relevant variables. What might justify contagion in a rational economy. Rational expectations and the effects of monetary policy. We develop a multiple rational expectations model of securities prices to explain the determinants of financial market contagion.
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