Financial crises and interacting heterogeneous agents

Weihong Huang, Huanhuan Zheng, Wai-Mun Chia

Journal of Economic Dynamics & Control 34 (2010) 1105–1122

Introduction:

1. Different crises exhibit themselves differently in terms of depth and length 
2. Forecasting the depth and length of the crises is hard 
3. The outcome of complicated combination of internal dynamics and external shocks 
4. Financial crises has a fundamental endogenous or internal origin where exogenous or external shocks only serve as triggering factors 
5. Heterogeneous agent model (HAM) 
6. Group crisis into three different types according to their depth and length - sudden crisis, smooth crisis and disturbing crisis

This Paper:

Model the three types of crises within the same deterministic HAM Building upon:

• the heterogeneous beliefs and the market-maker framework of Day and Huang (1990) 
• 
  
• the evolutionary framework of Brock and Hommes (1998) 
• 
  
• the discount mechanism of Lux and Marchesi (1999, 2000) 
• 
  
• the excess demand formation of Gennotte and Leland (1990) (with aggregate risk tolerance) 
• 
  
• in terms of the multi-phase belief system and the discounted expected profit from investors’ forward-looking behavior 

It is found that the internal price dynamics caused by the interactions of fundamentalists and chartists are sufficient to trigger all the three different types of crises.

Price dynamics

Normalize the aggregate excess demand with the weighted sum of all investor groups’ risk tolerance

γ measures the adjustment speed of the price

Equilibrium and stability

Conclusion:

• The interacting heterogeneous agent model (HAM) is capable of generating three typical types of financial crises that fit into real financial series.
• 
  
• First, the three different types of crises could be endogenous due to internal price dynamics.
• 
  
• Second, market structure, measured by market fraction index, is the key in price dynamics.
• 
  
• Third, although we do show that the fundamentalists play an important role in triggering crises, they do not take on full responsibility.
• 
  
• The chartists could be responsible in some scenarios such as smooth and disturbing crises.