News, Intermediation Efficiency and Expectations-driven Boom-bust Cycles
AbstractThe years leading up to the "great recession" were a time of rapid innovation in the financial industry. This period also saw a fall in interest rates, and a boom in liquidity that accompanied the boom in real activity, especially investment. In this paper we argue that these were not unrelated phenomena. The adoption of new financial products and practices led to a fall in the expected costs of intermediation which in turn engendered the flood of liquidity in the financial sector, lowered interest rate spreads and facilitated the boom in economic activity. When the events of 2007-2009 led to a re-evaluation of the effectiveness of these new products, agents revised their expectations regarding the actual efficiency gains available to the financial sector and this led to a withdrawal of liquidity from the financial system, a reversal in interest rates and a bust in real activity. We treat the efficiency of the financial sector as an exogenous process and study the impact of "news shocks" regarding this process. Following the expectations driven business cycle literature, we model the boom and bust cycle in terms of an expected future efficiency gain which is eventually not realized. The build up in liquidity and economic activity in expectation of these efficiency gains is then abruptly reversed when agent's hopes are dashed. The model generates counter-cyclical movements in the spread between lending rates and the risk-free rate which are driven purely by expectations, even in the absence of any exogenous movement in intermediation costs.
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Bibliographic InfoPaper provided by McMaster University in its series Department of Economics Working Papers with number 2011-02.
Length: 26 pages
Date of creation: Mar 2011
Date of revision:
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externalities; expectations-driven business cycles; intermediation shocks; credit shocks; financial intermediation; financial innovation; news shocks; business cycles.;
Find related papers by JEL classification:
- E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-03-26 (All new papers)
- NEP-CBA-2011-03-26 (Central Banking)
- NEP-DGE-2011-03-26 (Dynamic General Equilibrium)
- NEP-MAC-2011-03-26 (Macroeconomics)
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- Görtz, Christoph & Tsoukalas, John D., 2012.
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