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Financial innovation, the discovery of risk, and the U.S. credit crisis

  • Boz, Emine
  • Mendoza, Enrique G.

Financial innovation and overconfidence about the risk of new financial products were key factors behind the 2008 U.S. credit crisis. We show that a model with a collateral constraint in which learning about the risk of a new financial environment interacts with Fisherian amplification produces a boom–bust cycle in debt, asset prices and consumption. Early realizations of a high-borrowing-ability regime turn agents optimistic about the persistence probability of this regime. Conversely, the first realization of a low-borrowing-ability regime turns agents unduly pessimistic. The model predicts large increases in household debt, land prices and excess returns during 1998–2006 followed by a collapse.

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

Volume (Year): 62 (2014)
Issue (Month): C ()
Pages: 1-22

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Handle: RePEc:eee:moneco:v:62:y:2014:i:c:p:1-22
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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