Working Paper: NBER ID: w18036
Authors: Javier Bianchi; Emine Boz; Enrique G. Mendoza
Abstract: The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs played a central role in the 2008 financial crisis. This paper develops a quantitative general equilibrium framework in which this interaction drives the financial amplification mechanism to study the effects of macro-prudential policy. Financial innovation enhances the ability of agents to collateralize assets into debt, but the riskiness of this new regime can only be learned over time. Beliefs about transition probabilities across states with high and low ability to borrow change as agents learn from observed realizations of financial conditions. At the same time, the collateral constraint introduces a pecuniary externality, because agents fail to internalize the effect of their borrowing decisions on asset prices. Quantitative analysis shows that the effectiveness of macro-prudential policy in this environment depends on the government's information set, the tightness of credit constraints and the pace at which optimism surges in the early stages of financial innovation. The policy is least effective when the government is as uninformed as private agents, credit constraints are tight, and optimism builds quickly.
Keywords: macroprudential policy; financial innovation; credit frictions; beliefs; systemic risks
JEL Codes: D62; D82; E32; E44; F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial innovation (O16) | agents' ability to collateralize assets (G33) |
| agents' ability to collateralize assets (G33) | borrowing capacity (H74) |
| borrowing capacity (H74) | asset prices (G19) |
| credit constraints (E51) | asset prices (G19) |
| optimism about financial conditions (E66) | overborrowing (H74) |
| overborrowing (H74) | inflated asset prices (E31) |
| pessimism about financial conditions (E66) | underborrowing (G51) |
| underborrowing (G51) | deflationary pressures (E31) |
| underborrowing (G51) | fire sales of assets (G33) |
| tightness of borrowing constraints (F65) | effectiveness of macroprudential policy (E61) |
| government's information set (H11) | effectiveness of macroprudential policy (E61) |
| uninformed planner (D84) | less effective macroprudential policy (E61) |
| social planner with full information (D89) | more effective macroprudential policy (E61) |
| optimism and credit constraints (E51) | credit boom (F65) |
| optimism and credit constraints (E51) | financial crash (G01) |
| agents' misjudgment of riskiness (D81) | larger welfare losses (D69) |