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A macroeconomic model with a financial sector

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Author Info

  • Markus K. Brunnermeier

    ()
    (Department of Economics, Princeton University)

  • Yuliy Sannikov

    ()
    (Department of Economics, Princeton University)

Abstract

This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes - a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other and the economy by not maintaining adequate capital cushion.

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File URL: http://www.nbb.be/doc/oc/repec/reswpp/wp236En.pdf
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Bibliographic Info

Paper provided by National Bank of Belgium in its series Working Paper Research with number 236.

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Length: 75 pages
Date of creation: Oct 2012
Date of revision:
Handle: RePEc:nbb:reswpp:201210-236

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