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Financial innovation, macroeconomic stability and systemic crises

Listed author(s):
  • Prasanna Gai
  • Sujit Kapadia
  • Stephen P. 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 Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2006)
Issue (Month): Nov ()
Pages:

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Handle: RePEc:fip:fedfpr:y:2006:i:nov:x:17
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  1. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "Currency crises and monetary policy in an economy with credit constraints," European Economic Review, Elsevier, vol. 45(7), pages 1121-1150.
  2. Philippe Aghion & Abhijit Banerjee & Thomas Piketty, 1999. "Dualism and Macroeconomic Volatility," The Quarterly Journal of Economics, Oxford University Press, vol. 114(4), pages 1359-1397.
  3. Urban Jermann & Vincenzo Quadrini, 2007. "Financial Innovations and Macroeconomic Volatility," 2007 Meeting Papers 50, Society for Economic Dynamics.
  4. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  5. Demirguc-Kunt, Asli & Detragiache, Enrica, 2005. "Cross-country empirical studies of systemic bank distress : a survey," Policy Research Working Paper Series 3719, The World Bank.
  6. Luca Benati, 2004. "Evolving post-World War II UK economic performance," Bank of England working papers 232, Bank of England.
  7. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  8. Coval, Joshua & Stafford, Erik, 2007. "Asset fire sales (and purchases) in equity markets," Journal of Financial Economics, Elsevier, vol. 86(2), pages 479-512, November.
  9. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  10. Prasanna Gai & Peter Kondor & Nicholas Vause, 2006. "Procyclicality, collateral values and financial stability," Bank of England working papers 304, Bank of England.
  11. Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 809-833.
  12. Raghuram G. Rajan, 2005. "Has Financial Development Made the World Riskier?," NBER Working Papers 11728, National Bureau of Economic Research, Inc.
  13. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
  14. Morris, Stephen & Shin, Hyun Song, 1997. "Unique Equilibrium in a Model of Self-fulfilling Currency Attacks," CEPR Discussion Papers 1687, C.E.P.R. Discussion Papers.
  15. William R. White, 2004. "Are changes in financial structure extending safety nets?," BIS Working Papers 145, Bank for International Settlements.
  16. Patrick McGuire & Eli Remolona & Kostas Tsatsaronis, 2005. "Time-varying exposures and leverage in hedge funds," BIS Quarterly Review, Bank for International Settlements, March.
  17. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc.
  18. Hoggarth, Glenn & Reis, Ricardo & Saporta, Victoria, 2002. "Costs of banking system instability: Some empirical evidence," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 825-855, May.
  19. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  20. Franklin Allen & Douglas Gale, 2007. "Systemic Risk and Regulation," NBER Chapters, in: The Risks of Financial Institutions, pages 341-376 National Bureau of Economic Research, Inc.
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