A Model of Instability in Asset Markets

Abstract

Economic analysis relies predominantly on general equilibrium solutions of flows of production and consumption. Few economists have addressed the problems of financial instability in terms of stocks of assets. Hicks (1946, 62–7), in the original tour de force of modern general equilibrium analysis, did address the possibility of instability in markets for goods which were concurrently produced and consumed, that is, for a flow market. This is his famous “snake diagram,” which forms the basis of Figure 4.1. In this figure, excess supply increases (excess demand decreases) as the price of the good falls over a range of values but the instability is bounded by a stable equilibrium at both higher and lower prices. Because instability in markets for financial assets is crucial to an informed understanding of the dangers of dollar exhaustion for the likelihood of a “hard landing” for the US (and the global) economies, it is necessary to have a comparable model for instability in asset (stock) markets. This chapter provides such a model.