Abstract
This study reveals endogenous instability in the financial market based on the dynamic interaction between endogenous investment behavior and debt in a nonlinear framework, by using a nonlinear model predictive control (NMPC) approach. It is found that when the debt ratio is below a critical threshold, increased debt has a positive effect on investment. On the other hand, when the debt ratio is above that threshold, growing financial stress and greater debt become a drag on investment, leading to an economic downturn and an outbreak of financial crisis. The paper provides theoretical support for Minsky’s financial instability hypothesis.
Highlights
The traditional Keynesian macroeconomic theory considers the financial sector only as the intermediary for investment and cannot fully explain economic instability induced by a complex financial system [1]. [2] examines the relationship between the financial sector and the real sector and proposes the “financial instability hypothe-How to cite this paper: Chong, T.T.-L., Cebula, R.J., Peng, F.P. and Foley, M. (2015) Explaining the Financial Instability Hypothesis with Endogenous Investment: A Nonlinear Model Predictive Control Approach
To better model the dynamic mechanism of the financial instability hypothesis initially put forth by [2], we have developed a theoretical model describing the dynamics of the financial instability when the Capital Investment Debt economy is being exposed to shocks in credit spread
By using a nonlinear model predictive control approach, we have examined how financial instability is created endogenously
Summary
The traditional Keynesian macroeconomic theory considers the financial sector only as the intermediary for investment and cannot fully explain economic instability induced by a complex financial system [1]. [2] examines the relationship between the financial sector and the real sector and proposes the “financial instability hypothe-. As emphasized by [6], a theoretical analysis based on traditional log-linearization techniques is likely to be inadequate due to local instability and a non-linear amplification mechanism, which neither departs from nor reverts to the steady state. It does not track debt and investment dynamics. Much of the recent research emphasizes the role of asset prices and assetvolatility in downward destabilization, such as [7]-[9] and [10] These studies argue that large changes in assetprice movements trigger an endogenously generated jump in risk. A nonlinear model predictive control approach (NMPC) is employed to solve our model and to provide support for Minsky’s financial instability hypothesis
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