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Causes Of Financial Instability: Don't Forget Finance

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Executive Summary

Given the economy's complex behavior and sudden transitions as evidenced in the 2007-08 crisis, agent-based models are widely considered a promising alternative to current macroeconomic practice dominated by DSGE models. Their failure is commonly interpreted as a failure to incorporate heterogeneous interacting agents. This paper explains that complex behavior and sudden transitions also arise from the economy's financial structure as reflected in its balance sheets, not just from heterogeneous interacting agents. It introduces "Flow-of-funds" and "Accounting" models, which were preeminent in successful anticipations of the recent crisis.

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