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IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features

After the 2008 global financial crisis, many economists criticised the efficient markets and rational expectations framework underlying pre-crisis financial regulation. Which criticism is most consistent with behavioural and Keynesian thinking?

The consistent criticism is that asset prices can stray from fundamentals for long periods because of herding, overconfidence and animal spirits, so markets cannot be assumed to self-correct. This weakens the case for light-touch regulation based on efficient markets and rational expectations.

  1. AAsset prices can deviate from fundamentals for long periods because of herding, overconfidence and 'animal spirits', so self-correcting markets cannot be assumedCorrect
  2. BAsset bubbles are impossible because arbitrage removes mispricing immediately
  3. CCentral banks should never act as lenders of last resort because markets stabilise themselves
  4. DRegulation is unnecessary since firms internalise all systemic risks
  5. Financial crises arise only from changes in the money supply rule, never from sentiment

Explanation

Behavioural and Keynesian views stress sentiment, herding and animal spirits, which can drive prices away from fundamentals and create instability. Limits to arbitrage allow mispricing to persist. The other options reflect strong efficient-market or self-correcting assumptions that the crisis called into question.

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