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Evolutionary Dynamics in Financial Markets: Booms, Busts, and Policy

Paper Session

Sunday, Jan. 7, 2018 10:15 AM - 12:15 PM

Marriott Philadelphia Downtown, Liberty Ballroom Salon B
Hosted By: American Economic Association
  • Chair: Nobuhiro Kiyotaki, Princeton University

Variety Is the Spice of Life: Irrational Behavior as Adaptation to Stochastic Environments

Thomas Brennan
,
Harvard University
Andrew Lo
,
Massachusetts Institute of Technology
Ruixun Zhang
,
Massachusetts Institute of Technology

Abstract

The debate between rational models of behavior and their systematic deviations, often referred to as ``irrational behavior", has attracted an enormous amount of research. Here we reconcile the debate by proposing an evolutionary explanation for irrational behavior. In the context of a simple binary choice model, we show that irrational behaviors are necessary for evolution in stochastic environments. Furthermore, there is an optimal degree of irrationality in the population depending on the degree of environmental randomness. In this process, mutation provides the important link between rational and irrational behaviors, and hence the variety in evolution. Simulation confirms the generality of these implications in a wide range of stochastic environments. Our results yield widespread implications for finance, science, management, and public policy. The simplicity and generality of our model also suggest that these implications are primitive and cut across species, physiology, and genetic origins.

Financial Cycles with Heterogeneous Intermediaries

Nuno Coimbra
,
Paris School of Economics
Helene Rey
,
London Business School

Abstract

This paper develops a dynamic macroeconomic model with heterogeneous financial intermediaries and endogenous entry. It features time-varying endogenous macroeconomic risk that arises from the risk-shifting behaviour of financial intermediaries combined with entry and exit. We show that when interest rates are high, a decrease in interest rates stimulates investment and increases financial stability. In contrast, when interest rates are low, further stimulus can increase systemic risk and induce a fall in the risk premium through increased risk-shifting. In this case, the monetary authority faces a trade-off between stimulating the economy and financial stability.

Risk-taking Dynamics and Financial Stability

Anton Korinek
,
Johns Hopkins University
Martin Nowak
,
Harvard University

Abstract

We study how selection effects in the financial sector drive the dynamics of aggregate risk-taking and lead to novel effects of financial policy interventions. When financial market participants differ in their risk-taking, good shock realizations increase the capital of high risk-takers more than that of low risk-takers. This raises the fraction of wealth controlled by high risk-takers and, under incomplete markets, increases aggregate risk-taking. The opposite conclusions apply for bad shocks. As a result, aggregate risk-taking is pro-cyclical, capturing Minsky's financial instability hypothesis that “booms sow the seeds of the next crisis.” Public policy interventions work primarily via selection effects, i.e. by affecting the composition of the financial sector, in contrast to the static restriction on choice sets that is the focus of most conventional economic frameworks. For example, bailouts have deleterious effects not because they affect incentives but because they interfere with the natural capitalist selection process. Interventions to stabilize aggregate risk-taking, such as capital regulation, bring the economy closer to the first-best, increasing expected growth and reducing aggregate volatility.

Macroeconomic Effects of Secondary Market Trading

Daniel Neuhann
,
University of Texas-Austin

Abstract

This paper develops a theory of credit cycles to account for recent evidence that capital is increasingly allocated to inefficiently risky projects during credit booms. The model features lenders who sell risky assets to less informed investors in order to relax collateral constraints. When asset prices are high, however, these lenders begin producing and selling inefficiently risky assets. Asset prices rise during booms because the buyers of risky assets grow wealthy when their risk-taking pay offs, triggering a decline in investment efficiency and an increase in aggregate risk exposure. I study conditions that give rise to credit cycles and consider policy implications.
Discussant(s)
Arthur J. Robson
,
Simon Fraser University
Nobuhiro Kiyotaki
,
Princeton University
Eduardo Davila
,
New York University
Keshav Dogra
,
Federal Reserve Bank of New York
JEL Classifications
  • G1 - General Financial Markets
  • E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit