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Learning Leverage Shocks and the Great Recession

  • Pintus, P. A.
  • Suda, J.

This paper develops a simple business-cycle model in which financial shocks have large macroeconomic effects when private agents are gradually learning their economic environment. When agents update their beliefs about the unobserved process driving financial shocks to the leverage ratio, the responses of output and other aggregates under adaptive learning are significantly larger than under rational expectations. In our benchmark case calibrated using US data on leverage, debt-to-GDP and land value-to-GDP ratios for 1996Q1-2008Q4, learning amplifies leverage shocks by a factor of about three, relative to rational expectations. When fed with the actual leverage innovations, the learning model predicts the correct magnitude for the Great Recession, while its rational expectations counterpart predicts a counter-factual expansion. In addition, we show that procyclical leverage reinforces the impact of learning and, accordingly, that macro-prudential policies enforcing countercyclical leverage dampen the effects of leverage shocks. Finally, we illustrate how learning with a misspecified model that ignores real/financial linkages also contributes to magnify financial shocks.

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Paper provided by Banque de France in its series Working papers with number 440.

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Length: 55 pages
Date of creation: 2013
Date of revision:
Handle: RePEc:bfr:banfra:440
Contact details of provider: Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/

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  1. Fuster, Andreas & Hebert, Benjamin Michael & Laibson, David I., 2012. "Investment Dynamics with Natural Expectations," Scholarly Articles 10139283, Harvard University Department of Economics.
  2. Fabio Milani, 2011. "Expectation Shocks and Learning as Drivers of the Business Cycle," Economic Journal, Royal Economic Society, vol. 121(552), pages 379-401, 05.
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  4. Piketty, Thomas & Banerjee, Abhijit & Aghion, Philippe, 1997. "Dualism and macroeconomic volatility," CEPREMAP Working Papers (Couverture Orange) 9720, CEPREMAP.
  5. Midrigan, Virgiliu & Philippon, Thomas, 2011. "Household Leverage and the Recession," CEPR Discussion Papers 8381, C.E.P.R. Discussion Papers.
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  8. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2004. "Learning and shifts in long-run productivity growth," Working Paper Series 2004-04, Federal Reserve Bank of San Francisco.
  9. Nobuhiro Kiyotaki & Alexander Michaelides & Kalin Nikolov, 2011. "Winners and Losers in Housing Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 255-296, 03.
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  11. Zheng Liu & Pengfei Wang & Tao Zha, 2011. "Land-price dynamics and macroeconomic fluctuations," Working Paper Series 2011-26, Federal Reserve Bank of San Francisco.
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  13. Jermann, Urban & Quadrini, Vincenzo, 2009. "Macroeconomic Effects of Financial Shocks," CEPR Discussion Papers 7451, C.E.P.R. Discussion Papers.
  14. Atif Mian & Amir Sufi & Francesco Trebbi, 2011. "Foreclosures, House Prices, and the Real Economy," NBER Working Papers 16685, National Bureau of Economic Research, Inc.
  15. James B. Bullard & John Duffy, 2004. "Learning and structural change in macroeconomic data," Working Papers 2004-016, Federal Reserve Bank of St. Louis.
  16. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
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  18. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
  19. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
  20. Branch, William A. & Evans, George W., 2006. "A simple recursive forecasting model," Economics Letters, Elsevier, vol. 91(2), pages 158-166, May.
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  22. Urban Jermann & Vincenzo Quadrini, 2012. "Erratum: Macroeconomic Effects of Financial Shocks," American Economic Review, American Economic Association, vol. 102(2), pages 1186-1186, April.
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