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Financial Innovation, Macroeconomic Stability and Systemic Crises

  • Prasanna Gai
  • Sujit Kapadia
  • Stephen Millard
  • Ander Perez

We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and contains a clearly defined pecuniary externality associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, this externality is capable of generating a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past but potentially more severe. Copyright � Bank of England.

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Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): 118 (2008)
Issue (Month): 527 (03)
Pages: 401-426

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Handle: RePEc:ecj:econjl:v:118:y:2008:i:527:p:401-426
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