Paul Fontanier. Working Paper. “
Optimal Policy for Behavioral Financial Crises”.
Abstract
How should policymakers adapt their macroprudential and monetary policies when the fi- nancial sector is vulnerable to belief-driven boom-bust cycles? I develop a model in which fi- nancial intermediaries are subject to collateral constraints, and that features a general class of deviations from rational expectations. I show that distinguishing between the drivers of behav- ioral biases matters: when biases are a function of equilibrium asset prices, new externalities arise, even in models that do not have any room for policy in their rational benchmark. I build on this theory to examine policy implications. First, the policymaker should use counter-cyclical capital buffers and time-varying loan-to-value ratios. These restrictions must be strengthened in times of over-optimism, as well as when the regulator is concerned that over-pessimism will arise in a future crisis. Second, uncertainty about the precise extent of behavioral biases in finan- cial markets increases the incentives for the planner to act early. Finally, when biases depend on asset prices, an additional instrument is needed to act directly on asset prices. I study the use of monetary policy for this objective, and show that “leaning against the wind” can be desirable even when these macroprudential tools are unconstrained. The policymaker raises interest rates when there is a fear that high asset prices today, even if entirely warranted by fundamentals, can trigger extrapolation later on. Conventional monetary policy however loses power in normal times when agents expect the central bank to lean against the wind in the future.
Job Market Paper Online Appendix Francesca Bastianello and Paul Fontanier. Working Paper. “
Partial Equilibrium Thinking, Extrapolation, and Bubbles”.
AbstractWe model a financial market where some agents mistakenly attribute any price change they observe to new information alone, when in reality part of the price change is due to other agents’ buying/selling pressure, a form of bounded rationality that we refer to as “Partial Equilibrium Thinking” (PET). PET provides a microfoundation for price extrapolation, where the degree of extrapolation depends on the informational edge of informed agents. In normal times, this edge is constant and bubbles and crashes do not arise. By contrast, following a large one-off innovation in fundamentals that temporarily wipes out informed agents’ edge (a “displacement event”), extrapolation by PET traders is initially very aggressive but then gradually dies down, leading to bubbles and endogenous crashes. Micro-founding the degree of extrapolation in this way allows us to shed light on both normal market dynamics and on the Kindleberger (1978) narrative of bubbles within a unified framework.
Paper Francesca Bastianello and Paul Fontanier. Working Paper. “
Partial Equilibrium Thinking in General Equilibrium”.
Abstract
We develop a theory of "Partial Equilibrium Thinking" (PET), a type of misinference whereby agents fail to understand the general equilibrium consequences of their actions when inferring information from endogenous outcomes. PET generates a two-way feedback between outcomes and beliefs, which can lead to arbitrarily large deviations from fundamentals. In financial markets, PET equilibrium outcomes exhibit over-reaction, excess volatility, high trading volume, and return predictability. We draw a distinction between models of misinference and models with biases in Bayesian updating, and study how these two departures from rationality interact. We show that misinference from mistakenly assuming the world is rational can vastly amplify biases in Bayesian updating, and that the distinction between these two biases can have important quantitative implications.
Paper