Discussion paper

DP8439 Animal Spirits, Financial Crises and Persistent Unemployment

This paper develops a rational expectations model with multiple equilibrium unemployment rates where the price of capital may be unbounded above. I argue that this property is an important feature of any rational-agent explanation of a financial crisis, since for the expansion phase of the crisis to be rational, investors must credibly believe that asset prices could keep increasing forever with positive probability. I explain the sudden crash in asset prices that precipitates a financial crisis as a large negative self-fulfilling shock to the expectation of the future price of capital. This shock causes a permanent reduction in wealth and consumption and a permanent increase in the unemployment rate. My work suggests that economic policies designed to reduce the volatility of asset market movements will significantly increase economic welfare.


Farmer, R (2011), ‘DP8439 Animal Spirits, Financial Crises and Persistent Unemployment‘, CEPR Discussion Paper No. 8439. CEPR Press, Paris & London. https://cepr.org/publications/dp8439