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Financial Innovation, Macroeconomic Stability and Systemic Crises

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

Abstract

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.

Suggested Citation

  • Prasanna Gai & Sujit Kapadia & Stephen Millard & Ander Perez, 2008. "Financial Innovation, Macroeconomic Stability and Systemic Crises," Economic Journal, Royal Economic Society, vol. 118(527), pages 401-426, March.
    • Handle: RePEc:ecj:econjl:v:118:y:2008:i:527:p:401-426
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