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Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis

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  • Boz, Emine
  • Mendoza, Enrique G

Abstract

Uncertainty about the riskiness of a new financial environment was an important factor behind the U.S. credit crisis. We show that a boom-bust cycle in debt, asset prices and consumption characterizes the equilibrium dynamics of a model with a collateral constraint in which agents learn "by observation" the true riskiness of the new environment. Early realizations of states with high ability to leverage assets into debt turn agents overly optimistic about the probability of persistence of a high-leverage regime. Conversely, the first realization of the low-leverage state turns agents unduly pessimistic about future credit prospects. These effects interact with the Fisherian deflation mechanism, resulting in changes in debt, leverage, and asset prices larger than predicted under either rational expectations without learning or with learning but without Fisherian de°ation. The model can account for 69 percent of the rise in net household debt and 53 percent of the rise in residential land prices between 1997 and 2006, and it predicts a sharp collapse in 2007.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7967.

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Date of creation: Aug 2010
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Handle: RePEc:cpr:ceprdp:7967

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Related research

Keywords: asset prices; credit crisis; financial innovation; Fisherian deflation; imperfect information; learning;

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References

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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis
    by Christian Zimmermann in NEP-DGE blog on 2010-08-03 03:20:21
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Cited by:
  1. Enrique G. Mendoza & Marco E. Terrones, 2012. "An Anatomy of Credits Booms and their Demise," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 15(2), pages 04-32, August.
  2. Sudipto Bhattacharya & Charles Goodhart & Dimitrios Tsomocos & Alexandros Vardoulakis, 2011. "Minsky’s Financial Instability Hypothesis and the Leverage Cycle," FMG Special Papers sp202, Financial Markets Group.
  3. Pei Kuang, 2013. "Imperfect Knowledge about Asset Prices and Credit Cycles," Discussion Papers 13-02, Department of Economics, University of Birmingham.
  4. Vincenzo Quadrini, 2011. "Financial frictions in macroeconomic fluctations," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 209-254.
  5. Stijn Van Nieuwerburgh, 2012. "The Research Agenda: Stijn Van Nieuwerburgh on Housing and the Macroeconomy," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 13(2), April.
  6. Alejandro Justiniano & Giorgio E. Primiceri & Andrea Tambalotti, 2013. "Household Leveraging and Deleveraging," NBER Working Papers 18941, National Bureau of Economic Research, Inc.

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