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

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  • Enrique G. Mendoza
  • Emine Boz

Abstract

Uncertainty about the riskiness of new financial products 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 a new financial environment. Early realizations of states with high ability to leverage assets into debt turn agents optimistic about the persistence of a high-leverage regime. The model accounts for 69 percent of the household debt buildup and 53 percent of the rise in housing prices during 1997-2006, predicting a collapse in 2007.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 10/164.

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Length: 62
Date of creation: 01 Jul 2010
Date of revision:
Handle: RePEc:imf:imfwpa:10/164

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Related research

Keywords: Credit expansion; United States; Financial instruments; Household credit; Housing prices; Asset prices; Credit risk; Financial crisis; Economic models;

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References

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Citations

Blog mentions

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
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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Cited by:
  1. Patrick A. Pintus & Jacek Suda, 2013. "Learning Leverage Shocks and the Great Recession," AMSE Working Papers 1333, Aix-Marseille School of Economics, Marseille, France, revised 05 Jun 2013.
  2. Pei Kuang, 2013. "Imperfect Knowledge about Asset Prices and Credit Cycles," CDMA Working Paper Series 201303, Centre for Dynamic Macroeconomic Analysis.
  3. Alejandro Justiniano & Giorgio E. Primiceri & Andrea Tambalotti, 2013. "Household Leveraging and Deleveraging," NBER Working Papers 18941, National Bureau of Economic Research, Inc.
  4. repec:fip:fedreq:y:2011:i:3q:p:209-254:n:vol.97no.3 is not listed on IDEAS
  5. 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.
  6. 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.
  7. Vincenzo Quadrini, 2011. "Financial frictions in macroeconomic fluctations," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 209-254.
  8. 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.
  9. Patrick A. Pintus & Jacek Suda, 2014. "Learning Financial Shocks and the Great Recession," Working Papers halshs-00830480, HAL.

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