Heterogeneous Expectations and Financial Crises (HExFiCs)

This research project develops a new behavioral paradigm of heterogeneous expectations that can help explain the sources of financial and macroeconomic instability and find possible policy remedies.

The (de-)stabilizing effect of futures market and financial derivatives is a very important topic that helps to explain the origins and one of the main sources of the recent financial crisis. According to traditional economic theory, the introduction of complicated financial derivatives as a way of financial innovation promotes the efficiency and stability of the financial system. However, under the more realistic assumptions of boundedly rational heterogeneous, interacting agents switching between different forecasting heuristics based upon recent performance, financial innovation can destabilize financial markets and lead to large welfare losses. This project deviates from the mainstream Rational Expectation (RE) benchmark in economics and uses an alternative behavioral theory of heterogeneous expectations as a new paradigm in economics and finance and applies it to the current financial crisis.