Why are Economies Unstable? Research Project

Endogenous Extrapolation: Implications for Boom-Bust Cycles and Macroeconomic Policy

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Principal Investigator: Michael Hatcher

Dr Michael Hatcher is Lecturer in Economics within Economic, Social and Political Science at the University of Southampton.

Michael joined Southampton as a Lecturer in September 2014. He holds a PhD in Economics from Cardiff University and was ESRC Postdoctoral Fellow at the University of Glasgow. Prior to that, he taught economics for a year at the University of Oxford. Michael’s research interests are in the area of macroeconomic policy in general equilibrium models, with a focus on monetary policy, government debt, pensions and housing markets.

Project Summary

A key distinction between economies and physical systems, like the weather, is that economies consist of individuals who form expectations about the future. These beliefs influence the outcome of the system, but they also depend on it. At the same time, interest rates and GDP provide feedback that shapes our thinking about their future values. Expectations can be very powerful. An expectation that the economy will enter an upturn, for example, may generate enough economic activity to make the expectation a reality: expectations can be self-fulfilling.

My research project aims to investigate whether expectations drive big events like the Financial Crisis. We model expectations by recognising the cognitive limitations of individuals but also capture the feedback loop between expectations and macro outcomes outlined above. In particular, agents will be modelled as forming expectations using simple heuristics, or rules of thumb. There is considerable evidence – from psychology to experimental economics – that we behave along these lines. Some of the heuristics will be based on economic fundamentals; others will be extrapolative – taking recent outcomes and projecting them into the future.

We currently have a limited understanding of why big events happen and the types of policy interventions that are desirable in these circumstances. To shed light on these issues, models built during the project will include a stock market and a housing sector in which house purchases are financed by credit. Illiquidity of housing will be modelled explicitly: only a fraction of the houses available for sale each period will be sold. All models will be subject to empirical evaluations whose results will be made public. The ultimate aim is to improve our understanding of big events and shed light on the extent to which expectations matter.

Results

Working Paper

Stock Price Stabilization? Permanent vs Temporary Short-Sales Limits in a

Heterogeneous Beliefs Model

Michael Hatcher | June 1, 2020

 

Abstract:

Recent turmoil on global financial markets has sparked a lively discussion of whether such markets can and should be stabilized. Several countries subsequently introduced short-selling bans or restrictions. This paper investigates the impact of such restrictions on financial stability in a stochastic asset pricing model with heterogeneous beliefs. We find that both permanent and temporary short-sales limits lead to overpricing, but di↵er in their impact on price volatility. Permanent short sales limits raise price volatility and increase the incidence of explosive price bubbles. Temporary short-sales limits – introduced in response to falling prices – lower price volatility. If updating of beliefs is strong enough, the incidence of explosive price bubbles is also reduced. Temporary limits triggered by a single period of falling prices are outperformed by more ‘patient’ regulation in terms of overpricing and volatility. However, ‘quick-fire’ short-sales limits may reduce the risk of explosive bubbles if belief updating is not too strong. We show the model can reproduce some stylized facts of stock market returns.


Keywords: Stock prices, heterogeneous beliefs, short selling, financial stability.

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