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10/2010

 

DEPFID Working Papers - 10 / 2010 - Abstract

 

 

Heterogeneous expectations and strong uncertainty

in a Minskyian model of financial fluctuations

 

Serena Sordi and Alessandro Vercelli

 

We examine the role of expectations in a model aimed to explain financial fluctuations. The model restates the core of Minsky’s financial instability hypothesis, focusing on the role of expectations. The hypotheses concerning the process of formation and revision of expectations are discussed in light of Keynes’s epistemological view of the behaviour of boundedly rational agents under conditions of strong uncertainty. These hypotheses are formalized by drawing on recent advances in complex dynamics, decision theory and behavioural economics. We show that widespread use of extrapolative expectations by economic agents produces a high degree of financial instability that may lead to a serious financial crisis, and that the use by economic agents of a mix of extrapolative and regressive expectations reduces the dynamical instability of the model but may give rise to complex dynamics.

 

Keywords: financial instability, heterogeneous expectations, extrapolative expectations, regressive expectations, complex dynamics

 

JEL Classification: G01, C61, D84

 

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Acknowledgements: We are grateful for their useful comments and suggestions to the colleagues who participated in the 6th Conference on ‘Nonlinear Economic Dynamics’ (Jonkoping, Sweden, June 2009), the 18th Annual Symposium of the Society for Nonlinear Dynamics & Econometrics (Novara, April 2010), the 16th Conference of the Society for Computational Economics (London, UK, July 2010) and the Conference on ‘Can it Happen Again? Sustainable Policies to Mitigate and Prevent Financial Crisis’ (Macerata, Italy, October 2010), where previous versions of this paper were presented. The usual disclaimer applies.

 

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Dipartimento di Politica Economica, Finanza e Sviluppo – Università di Siena