Working Paper: CEPR ID: DP13875
Authors: Marzio Bassanin; Ester Faia; Valeria Patella
Abstract: Financial crises often originate in debt markets, where collateral constraints and opacity of asset values generate intrinsic instability. In such ambiguous contexts endogenous beliefs formation plays a crucial role in explaining asset price and leverage cycles. We introduce state-contingent ambiguity attitudes embedding ambiguity aversion and seeking, which endogenously induces pessimism (left-skewed beliefs) in recessions and optimism (rightskewed beliefs) in booms, in a model where borrowers face occasionally binding collateral constraints. We use GMM estimation with latent value functions to estimate the ambiguity attitudes process. By simulating a crisis scenario in our model we show that optimism in booms is responsible for higher asset price and leverage growth and pessimism in recessions is responsible for sharper de-leveraging and asset price bursts. Analytically and numerically (using global methods) we show that our state-contingent ambiguity attitudes coupled with the collateral constraints can explain relevant asset price and debt cycle facts around the unfolding of a financial crisis.
Keywords: ambiguity attitudes; occasionally binding constraints; kinked multiplier preferences; leverage cycle; asset price cycle
JEL Codes: E0; E5; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimism during economic booms (E32) | higher asset prices (G19) |
| optimism during economic booms (E32) | leverage growth (O00) |
| pessimism during recessions (E32) | sharper deleveraging (F65) |
| pessimism during recessions (E32) | asset price declines (G19) |
| beliefs (D83) | value of collateral (G32) |
| value of collateral (G32) | slackening of collateral constraints (G33) |
| slackening of collateral constraints (G33) | greater debt accumulation (H63) |
| state of the economy (E66) | endogenous formation of beliefs (D83) |
| state of the economy (E66) | left-skewed beliefs in bad times (G41) |
| state of the economy (E66) | right-skewed beliefs in good times (G41) |
| ambiguity attitudes and collateral constraints (D80) | asset price volatility (G19) |
| ambiguity attitudes and collateral constraints (D80) | procyclical nature of leverage (E44) |