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Boom–bust cycles: Leveraging, complex securities, and asset prices

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  • Semmler, Willi
  • Bernard, Lucas

Abstract

Recent history suggests that many boom–bust cycles are naturally driven by linkages between the credit market and asset prices. Additionally, new structured securities have been developed, e.g., MBS, CDOs, and CDS, which have acted as instruments of risk transfer. We show that there is a certain non-robustness in the pricing of these instruments and we create a model in which both their role in the recent financial market meltdown, and in which the mechanism by which they exacerbate leverage cycles, is explicit. We first discuss the extent to which complex securities can amplify boom–bust cycles. Then, we propose a model in which distinct financial market boom–bust cycles emerge naturally. We demonstrate the interaction of leveraging and asset pricing in a dynamical model and spell out some implications for monetary policy.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Behavior & Organization.

Volume (Year): 81 (2012)
Issue (Month): 2 ()
Pages: 442-465

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Handle: RePEc:eee:jeborg:v:81:y:2012:i:2:p:442-465

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Web page: http://www.elsevier.com/locate/jebo

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Keywords: Credit; Leverage; Mortgage; Credit risk; Structured finance; Leveraged financing; Mortgage-backed security; Collateral; Collateralized default obligation; Booms; Busts; Dynamic; Cycles;

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References

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  1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  2. Vasco Curdia & Michael Woodford, 2010. "Credit Spreads and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 3-35, 09.
  3. Grune, Lars & Semmler, Willi, 2004. "Using dynamic programming with adaptive grid scheme for optimal control problems in economics," Journal of Economic Dynamics and Control, Elsevier, vol. 28(12), pages 2427-2456, December.
  4. Monika Piazzesi & Martin Schneider & Selale Tuzel, 2004. "Housing, Consumption and Asset Pricing," 2004 Meeting Papers 357c, Society for Economic Dynamics.
  5. Simon G. Gilchrist & Ben Bernanke & Mark Gertler, 1994. "The financial accelerator and the flight to quality," Finance and Economics Discussion Series 94-18, Board of Governors of the Federal Reserve System (U.S.).
  6. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1999. "Hedging and financial fragility in fixed exchange rate regimes," Working Paper Series WP-99-11, Federal Reserve Bank of Chicago.
  7. Andreas R?thig & Willi Semmler & Peter Flaschel, 2006. "Hedging, Speculation, and Investment in Balance-Sheet Triggered Currency Crises," Research Paper Series 173, Quantitative Finance Research Centre, University of Technology, Sydney.
  8. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  9. Semmler, Willi & Sieveking, Malte, 2000. "Critical debt and debt dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 24(5-7), pages 1121-1144, June.
  10. Sebastian Edwards, 1999. "Crisis Prevention: Lessons from Mexico and East Asia," NBER Working Papers 7233, National Bureau of Economic Research, Inc.
  11. Robert J. Shiller, 2006. "Long-Term Perspectives on the Current Boom in Home Prices," The Economists' Voice, De Gruyter, vol. 3(4), pages 4.
  12. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  13. Marcus Miller & Joseph Stiglitz, 2010. "Leverage and Asset Bubbles: Averting Armageddon with Chapter 11?," Economic Journal, Royal Economic Society, vol. 120(544), pages 500-518, 05.
  14. Gallegati, Mauro & Palestrini, Antonio & Rosser, J. Barkley, 2011. "The Period Of Financial Distress In Speculative Markets: Interacting Heterogeneous Agents And Financial Constraints," Macroeconomic Dynamics, Cambridge University Press, vol. 15(01), pages 60-79, February.
  15. Lars Grüne & Willi Semmler & Malte Sieveking, 2005. "Creditworthiness and thresholds in a credit market model with multiple equilibria," Economic Theory, Springer, vol. 25(2), pages 287-315, 02.
  16. Tobias Adrian & Hyun Song Shin, 2009. "Money, liquidity, and monetary policy," Staff Reports 360, Federal Reserve Bank of New York.
  17. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  18. Grüne, Lars & Semmler, Willi, 2008. "Asset pricing with loss aversion," Journal of Economic Dynamics and Control, Elsevier, vol. 32(10), pages 3253-3274, October.
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Citations

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Cited by:
  1. Stefan Mittnik & Willi Semmler, 2013. "The Real Consequences of Financial Stress," SFB 649 Discussion Papers SFB649DP2013-011, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  2. Asada, Toichiro & Chiarella, Carl & Flaschel, Peter & Mouakil, Tarik & Proaño, Christian R., 2010. "Stabilizing an unstable economy: On the choice of proper policy measures," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 4(21), pages 1-43.

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