Economic Theory - Andy McLennan (UQ)

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Location: Level 1 Theatre, The Spot

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Simon Loertscher

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Title: A Minskyite Model of Financial Crises
Abstract: This paper is the first to present Minsky’s financial instability hypothesis in a formal model with cycles that are endogenous, rather than responses to exogenous shocks. In the model, there are entrepreneurs and investors. Entrepreneurs may be either Good or Bad. A matched pair (a firm) may undertake a costly audit, which reduces the risk that a Bad entrepreneur incurs a disaster, and also exposes a Bad entrepreneur with some probability. There is a constant flow of Bad entrepreneurs into the market, and Bad entrepreneurs exit as a result of disaster, detection, and retirement.  When there are only a few Bad entrepreneurs, auditing is not worthwhile, and when there are many, all firms audit.  There is an intermediate range in which firms prefer to audit, or not, according to whether other firms audit.  Without auditing, the fraction of Bad entrepreneurs increases, and eventually there may be a sudden transition to all firms auditing, which is a financial crisis that causes a recession.  Depending on parameters, a lender of last resort may be able to prevent crises.