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Fire sales and the financial accelerator

  • Choi, Woon Gyu
  • Cook, David

During financial turmoil, increases in risk lead to higher default, foreclosure, and fire sales. This paper introduces a costly liquidation process for foreclosed collateral and pro-cyclical recovery rates in a dynamic stochastic general equilibrium model of the financial accelerator. Links between endogenous recovery rates, risk premia, and default risk generate a liquidity spiral, magnifying financial accelerator effects. We illustrate how collateral liquidation and monetary policy alter the real impact of financial shocks operating through macro-financial linkages; and the way a government subsidy on collateral liquidity and required liquidity buffers can help dampen the liquidity spiral by shoring up recovery rates.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 59 (2012)
Issue (Month): 4 ()
Pages: 336-351

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Handle: RePEc:eee:moneco:v:59:y:2012:i:4:p:336-351
DOI: 10.1016/j.jmoneco.2012.04.001
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