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. 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. A basic example of rational expectations theory is a situation in which a consumer delays buying a certain good because, based on hisher observations and experiences, heshe believes that the price will be less expensive in. 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. In particular, the model explains the characteristics. This paper investigates the informational role of prices in segmented markets which are shocked by a kind of common sentiment resulting from financial contagion. 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. Asymmetric price movements and borrowing constraints. A rational expectations model of financial contagion 771 nel is not wholly satisfying for a different reason. 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. A rational expectations model of financial contagion by laura.
Rational expectations and the effects of monetary policy. A rational expectations model of financial contagion finance and economics discussion series. Rational expectations 319 distributed random variables 8t with zero mean and variance a2. A consistency condition under rational expectations implies erik r, since r is an expectation based on free information and the p. Rational expectations hypothesis financial definition of. 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. This study examines how heterogeneity of private information may induce financial contagion. Rational expectations ensure internal consistency in models involving uncertainty.
Rational expectations models in macroeconomics john b. A rational expectation model of financial contagion request pdf. Solving a model using full information rational expectations as the equilibrium concept involves integrating out expectations terms from the structural equations of the model by replacing agents expectations with the mathematical expectation, conditional on the state of the model. 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. This common sentiment bridges the connection between prices learned by rational traders and thus can weaken the uncertainty from noise shock. Finance and economics discussion series feds federal reserve. Rational expectations an overview sciencedirect topics.
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. Pdf imperfect competition, information heterogeneity, and. Theory of rational expectation theories macroeconomics.
A key feature of our model is that it generates contagion without the release of public news or other information. A rational expectations model of financial contagion federal. However, the idea was not widely used in macroeconomics until the new classical revolution of the early 1970s, popularized by robert lucas and t. Rational expectations and the theory of price movements. In a nutshell, that is the rational expectations hypothesis. Although themodel allows contagion through several chan. Financial fragility with rational and irrational exuberance. A rational expectations model of financial contagion, journal of finance, 57. The rational expectations theory is a concept and modeling technique that is used widely in macroeconomics. Their work presents a further mechanism of contagion.
Such phenomenon is explained by models of expectations formation in the context of. For any square matrix w, w 1awis a so called similarity transformation of a. B financial market contagion recent research has greatly improved the understanding of financial contagion. The incentives for equating expectations with optimal forecasts are especially strong in financial markets. No 199848, finance and economics discussion series from board of governors of the federal reserve system u. Although the model allows contagion through several channels, our focus is on contagion through crossmarket rebalancing. Using our model we provide a potential explanation for the uneven pattern of nancial market contagion.
Request pdf a rational expectation model of financial contagion we develop a multiple asset rational expectations model of asset prices to explain. Our findings show that the pattern and severity of financial contagion depends on the size of markets sensitivities to common macroeconomic. 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. Abstract we develop a multiple asset rational expectations model of asset prices to explain financial market contagion. What might justify contagion in a rational economy. Macroeconomic analysis without the rational expectations. A rational expectations model of financial contagion by.
The authors find that there exist comovement effect and crowdingout effect in information. A rational expectations model of financial contagion kodres. 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 equilibrium model of crises, contagion, and confusion kathy yuan. We develop a multiple rational expectations model of securities prices to explain the determinants of financial market contagion.
A rational expectations model of financial contagion pdf laura e. A rational expectations model of financial contagion, board of governors of the federal reserve system, mimeo, october. Rational contagion and the globalization of securities. 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. Rational expectations equilibrium is common in macroeconomic studies, especially when the model has few agents and assets or when there is no aggregate risk.
Section vi relates the properties of the model to the patterns of contagion in recent crises. The theory posits that individuals base their decisions on three primary factors. Financial contagion and attention allocation university of toronto. Feds working paper 199848, the federal reserve board. A rational expectations model of financial contagion laura e. The current debate on financial contagion is motivated by a number of policy questions. The next section presents our general model of asset prices. 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. Muth of indiana university first proposed the theory of rational expectations in the early period of 1960s. Investors forecast the likelihood of loss from contagion and may shift preemptively to safer portfolios, breaking portfolio linkages in the process. Request pdf a rational expectation model of financial contagion we develop a multiple asset rational expectations model of asset prices to explain financial market 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. A rational expectations model of financial contagion core.
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. This would make rumors r of rational expectations when applied to financial markets, is known as. A rational expectations model of financial contagion by laura e. To obtain consistency within a model, the predictions of future values of economically relevant variables. 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. Lecture notes 4 the monetary approach under rational expectations.
We develop a multiple asset rational expectations model of asset prices to study the determinants of financial market contagion, and to provide an explanation. This would make rumors r rational expectations model of financial contagion laurae. In this paper we present a rational expectations, nancial model of contagion. The rational expectations hypothesis is that the expectations relevant to economic outcomes are appropriately proxied by the forecasts derived from the economists model. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios exposures to shared macroeconomic risks. 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. In this paper, we present a model of financial contagion which formalizes this latter. Consistent with empirical observations, the model finds. 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. Abstract this study proposes a rational expectations equilibrium model of crises and contagion in an economy with information asymmetry and borrowing constraints. When agents are hit by a shock in one market, they need to rebalance their portfolio of assets.
The rational expectations theory is an economic idea that the people make choices based on their rational outlook, available information and past experiences. 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. 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. 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.
The stock market, the theory of rational expectations. A rational expectations model of financial contagion, journal of finance 57 2, pp. Similarity transformations has the property that they do not change the eigenvalues of a matrix, so t. A rational expectations model of financial contagion laurae. We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. The properties of the model for contagion are explored in sections ii through v. The model of contagion presented in this paper is a multiple asset, noisy rational expectations.
Pritsker 2002, a rational expectations model of financial contagion, journal of finance 57 2, pp. Contagion is commonly referred to being the result of herding behaviour. 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. Kodres and others published a rational expectations model of financial contagion find, read and cite all the research you need on researchgate. The model presented generates a financial structure with portfolio linkages that make it susceptible to contagious financial crises, despite the absence of coordination failures. Although the model allows contagion through several channels, our focus is on contagion through cross. A rational expectations model of financial contagion finance. A rational expectations model of financial contagion. Read this article to learn about the seven major implications and challenges of rational expectations. Rational expectations theory definition investopedia.
A rational expectations model of financial contagion finance and economics discussion series kodres, laura e on. A rational expectations model of financial contagion created date. Model of financial contagion, journal of finance 57. No doubt, the theory of rational expectations is a major breakthrough in macroeconomics.
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