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Macro-prudential Policy in a Fisherian Model of Financial Innovation

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  • 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.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 12/181.

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Length: 54
Date of creation: 01 Jul 2012
Date of revision:
Handle: RePEc:imf:imfwpa:12/181

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Keywords: Economic models; Macroprudential Policy; collateral; financial innovation; bond; bonds; derivative; price derivative; financial reforms; equilibrium asset prices; financial regulation; international financial statistics; financial intermediaries; financial markets; financial system; financial fragility; financial instruments; discount bond; commodity futures; financial instability; asset markets; bond market;

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References

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  1. Nicola Gennaioli & Andrei Shleifer, 2010. "What Comes to Mind," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 125(4), pages 1399-1433, November.
  2. Boz, Emine & Mendoza, Enrique G, 2010. "Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7967, C.E.P.R. Discussion Papers.
  3. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers, Federal Reserve Bank of Minneapolis 445, Federal Reserve Bank of Minneapolis.
  4. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2010. "Financial Crises and Macro-Prudential Policies," CEP Discussion Papers, Centre for Economic Performance, LSE dp1032, Centre for Economic Performance, LSE.
  5. Nicola Gennaioli & Andrei Shleifer & Robert Vishny, 2010. "Neglected risks, financial innovation and financial fragility," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 1251, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2010.
  6. Enrique G. Mendoza & Marco E. Terrones, 2008. "An anatomy of credit booms: evidence from macro aggregates and micro data," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 936, Board of Governors of the Federal Reserve System (U.S.).
  7. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  8. Javier Bianchi, 2010. "Overborrowing and Systemic Externalities in the Business Cycle," 2010 Meeting Papers, Society for Economic Dynamics 96, Society for Economic Dynamics.
  9. Jonathan Heathcote & Morris Davis, 2004. "The Price and Quantity of Residential Land in the United States," 2004 Meeting Papers, Society for Economic Dynamics 32, Society for Economic Dynamics.
  10. Marco Terrones & Enrique G. Mendoza, 2008. "An Anatomy of Credit Booms," IMF Working Papers, International Monetary Fund 08/226, International Monetary Fund.
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Cited by:
  1. Emine Boz & Enrique G. Mendoza, 2010. "Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis," NBER Working Papers 16020, National Bureau of Economic Research, Inc.
  2. Lane, Philip R. & McQuade, Peter, 2013. "Domestic credit growth and international capital flows," Working Paper Series, European Central Bank 1566, European Central Bank.
  3. Luisa Lambertini & Caterina Mendicino & Maria Teresa Punzi, 2011. "Leaning Against Boom-Bust Cycles in Credit and Housing Prices," Working Papers, Center for Fiscal Policy, Swiss Federal Institute of Technology Lausanne 201101, Center for Fiscal Policy, Swiss Federal Institute of Technology Lausanne, revised Mar 2011.
  4. Javier Bianchi & Enrique G. Mendoza, 2013. "Optimal Time-Consistent Macroprudential Policy," NBER Working Papers 19704, National Bureau of Economic Research, Inc.
  5. Juan Pablo Medina Guzman & Jorge Roldos, 2014. "Monetary and Macroprudential Policies to Manage Capital Flows," IMF Working Papers, International Monetary Fund 14/30, International Monetary Fund.
  6. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
  7. Anton Korinek & Enrique G. Mendoza, 2013. "From Sudden Stops to Fisherian Deflation: Quantitative Theory and Policy Implications," NBER Working Papers 19362, National Bureau of Economic Research, Inc.

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