ABSTRACT
This chapter explores impacts on the macroeconomy, to explain how and why unstable financial systems create problems for the “real side” of the macroeconomy, in terms of slowing growth and rising unemployment, and what can be done about it. Behavioural and psychological factors place limits on rational trading, allowing financial instability to spread. In addition to other forms of bias, financial instability will be exacerbated by present bias and distortions to inter-temporal preferences. In explaining financial instability at an aggregate level, a key point is that the consequences of short-termism are not confined to householders and will have consequences for financial stability more generally. Speculative bubbles are an essential feature of financial instability. In the place of standard assumptions of rationality and efficient markets, George Akerlof and Robert Shiller argue that financial instability is driven by forces of spontaneous optimism and pessimism in financial markets.
