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Macroprudential Policy in a Fisherian Model of Financial Innovation

  • Javier Bianchi
  • Emine Boz
  • Enrique Gabriel Mendoza

The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs played a central role in the 2008 financial crisis. This paper develops a quantitative general equilibrium framework in which this interaction drives the financial amplification mechanism to study the effects of macroprudential policy. Financial innovation enhances the ability of agents to collateralize assets into debt, but the riskiness of this new regime can only be learned over time. Beliefs about transition probabilities across states with high and low ability to borrow change as agents learn from observed realizations of financial conditions. At the same time, the collateral constraint introduces a pecuniary externality, because agents fail to internalize the effect of their borrowing decisions on asset prices. Quantitative analysis shows that the effectiveness of macroprudential policy in this environment depends on the government's information set, the tightness of credit constraints, and the pace at which optimism surges in the early stages of financial innovation. The policy is least effective when the government is as uninformed as private agents, credit constraints are tight, and optimism builds quickly.

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Article provided by Palgrave Macmillan in its journal IMF Economic Review.

Volume (Year): 60 (2012)
Issue (Month): 2 (July)
Pages: 223-269

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Handle: RePEc:pal:imfecr:v:60:y:2012:i:2:p:223-269
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  1. Benigno, Gianluca & Chen, Huigang & Otrok, Christopher & Rebucci, Alessandro & Young, Eric R, 2011. "Financial Crisis and Macro-Prudential Policies," CEPR Discussion Papers 8175, C.E.P.R. Discussion Papers.
  2. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 15114, University Library of Munich, Germany.
  3. Enrique Mendoza & Emine Boz, 2010. "Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis," 2010 Meeting Papers 316, Society for Economic Dynamics.
  4. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
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  6. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute.
  7. Nicola Gennaioli & Andrei Shleifer & Robert W. Vishny, 2010. "Neglected Risks, Financial Innovation, and Financial Fragility," NBER Working Papers 16068, National Bureau of Economic Research, Inc.
  8. Nicola Gennaioli & Andrei Shleifer, 2009. "What Comes to Mind," NBER Working Papers 15084, National Bureau of Economic Research, Inc.
  9. Enrique G. Mendoza & Marco E. Terrones, 2008. "An Anatomy Of Credit Booms: Evidence From Macro Aggregates And Micro Data," NBER Working Papers 14049, National Bureau of Economic Research, Inc.
  10. Anton Korinek, 2011. "Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses," NFI Working Papers 2011-WP-13, Indiana State University, Scott College of Business, Networks Financial Institute.
  11. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
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