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The Myth of Financial Innovation and the Great Moderation

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Author Info

  • Wouter J. Den Haan
  • Vincent Sterk

Abstract

Financial innovation is widely believed to be at least partly responsible for the recent financial crisis. At the same time, there are empirical and theoretical arguments that support the view that changes in financial markets played a role in the "great moderation". If both are true, then the price of reducing the likelihood of another crisis, e.g., through new regulation, could be giving up another episode of sustained growth and low volatility. However, this paper questions empirical evidence supporting the view that innovation in consumer credit and home mortgages reduced cyclical variations of key economic variables. We find that especially the behaviour of aggregate home mortgages changed less during the great moderation than is typically believed. For example, aggregate home mortgages declined during monetary tightenings, both before and during the great moderation. A remarkable change we do find is that monetary tightenings became episodes during which financial institutions other than banks increased their holdings in mortgages. Once can question the desirability of such strong substitutions of ownership during economic downturns.

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Bibliographic Info

Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): 121 (2011)
Issue (Month): 553 (06)
Pages: 707-739

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Handle: RePEc:ecj:econjl:v:121:y:2011:i:553:p:707-739

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  1. Jonathan McCarthy & Richard W. Peach, 2002. "Monetary policy transmission to residential investment," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 139-158.
  2. Iacoviello, Matteo & Pavan, Marina, 2013. "Housing and debt over the life cycle and over the business cycle," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 221-238.
  3. Urban Jermann & Vincenzo Quadrini, 2006. "Financial innovations and macroeconomic volatility," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  4. Stephen G. Cecchetti & Alfonso Flores-Lagunes & Stefan Krause, 2006. "Assessing the Sources of Changes in the Volatility of Real Growth," NBER Working Papers 11946, National Bureau of Economic Research, Inc.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. "The Elevated Position of the Financial Sector"
    by Mark Thoma in Economist's View on 2011-10-27 07:24:00
  2. "The Elevated Position of the Financial Sector"
    by Economists View in FavStocks on 2011-10-28 10:02:14
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Cited by:
  1. Roland Meeks & Benjamin Nelson & Piergiorgio Alessandri, 2013. "Shadow banks and macroeconomic instability," CAMA Working Papers 2013-78, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  2. Grydaki, Maria & Bezemer, Dirk, 2013. "The role of credit in the Great Moderation: A multivariate GARCH approach," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4615-4626.
  3. Gaetano Antinolfi & Celso Brunetti, 2013. "Economic volatility and financial markets: the case of mortgage-backed securities," Finance and Economics Discussion Series 2013-42, Board of Governors of the Federal Reserve System (U.S.).

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