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Financial cycles under diagnostic beliefs

Author

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  • Camous, Antoine
  • Van der Ghote, Alejandro

Abstract

Swift changes in investors' sentiment, such as the one triggered by COVID-19 global outbreak in March 2020, lead to financial tensions and asset price volatility. We study the interactions of behavioral and financial frictions in an environment with endogenous risk-taking and capital accumulation. Agents form diagnostic expectations about future stochastic outcomes: recent realizations of aggregate shocks are expected to persist. This behavioral friction gives rise to sentiment cycles with excessive investment and occasional safety traps. The interactions with financial frictions lead to an endogenous amplification of financial instability. We discuss implications for policy interventions. JEL Classification: E32, E44, E71

Suggested Citation

  • Camous, Antoine & Van der Ghote, Alejandro, 2022. "Financial cycles under diagnostic beliefs," Working Paper Series 2659, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20222659
    Note: 2828013
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    References listed on IDEAS

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    More about this item

    Keywords

    diagnostic beliefs; financial cycles; macro-prudential policy;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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