Advanced Search
MyIDEAS: Login to save this paper or follow this series

News, Credit Spreads and Default Costs: An expectations-driven interpretation of the recent boom-bust cycle in the U.S

Contents:

Author Info

  • Christopher M. Gunn
  • Alok Johri

Abstract

The years leading up to the "great recession" were a time of rapid innovation in the financial industry. This period also saw a fall in credit spreads and a boom in liquidity and asset prices 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 default which in turn engendered the flood of liquidity in the financial sector, lowered interest rate spreads and facilitated the boom in asset prices and 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 credit spreads and asset prices and a bust in real activity. We treat the efficiency of the financial sector as an exogenous process governing bankruptcy (monitoring) costs facing intermediaries in a costly state verification framework 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 fall in bankruptcy costs which are 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 as well as an endogenous rise and fall in asset prices and leverage.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://socserv.mcmaster.ca/econ/rsrch/papers/archive/2012-04.pdf
Download Restriction: no

Bibliographic Info

Paper provided by McMaster University in its series Department of Economics Working Papers with number 2012-04.

as in new window
Length: 41 pages
Date of creation: May 2012
Date of revision:
Handle: RePEc:mcm:deptwp:2012-04

Contact details of provider:
Postal: 1280 Main Street West, Hamilton, Ontario, L8S 4M4
Phone: (905) 525-9140 ext. 22765
Fax: (905) 521-8232
Email:
Web page: http://www.economics.mcmaster.ca/
More information through EDIRC

Related research

Keywords: expectations-driven business cycles; intermediation shocks; credit shocks; financial intermediation; financial innovation; news shocks; business cycles; costly state verification; leverage; financial accelerator;

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Lawrence Christiano & Cosmin L. Ilut & Roberto Motto & Massimo Rostagno, 2010. "Monetary Policy and Stock Market Booms," NBER Working Papers 16402, National Bureau of Economic Research, Inc.
  2. Nolan, Charles & Thoenissen, Christoph, 2009. "Financial shocks and the US business cycle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 56(4), pages 596-604, May.
  3. Hashmat Khan & John Tsoukalas, 2009. "The Quantitative Importance of News Shocks in Estimated DSGE Models," Carleton Economic Papers, Carleton University, Department of Economics 09-07, Carleton University, Department of Economics, revised 22 May 2012.
  4. Alok Johri & Christopher Gunn, 2009. "News and knowledge capital," 2009 Meeting Papers, Society for Economic Dynamics 763, Society for Economic Dynamics.
  5. Nolan, Charles & Thoenissen, Christoph, 2008. "Financial shocks and the US business cycle," SIRE Discussion Papers, Scottish Institute for Research in Economics (SIRE) 2008-58, Scottish Institute for Research in Economics (SIRE).
  6. Robert Amano & Malik Shukayev, 2009. "Risk Premium Shocks and the Zero Bound on Nominal Interest Rates," Working Papers, Bank of Canada 09-27, Bank of Canada.
  7. Paul Beaudry & Amartya Lahiri, 2009. "Risk Allocation, Debt Fueled Expansion and Financial Crisis," NBER Working Papers 15110, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Gunn, Christopher M. & Johri, Alok, 2013. "An expectations-driven interpretation of the “Great Recession”," Journal of Monetary Economics, Elsevier, Elsevier, vol. 60(4), pages 391-407.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:mcm:deptwp:2012-04. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.