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Imperfect Knowledge about Asset Prices and Credit Cycles

  • Pei Kuang
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    I develop an equilibrium model with collateral constraints in which rational agents are uncertain and learn about the equilibrium mapping between fundamentals and collateral prices. Bayesian updating of beliefs by agents can endogenously generate booms and busts in collateral prices and largely strengthen the role of colateral constraints as an amplification mechanism through the interaction of agents' beliefs, collateral prices and credit limits. Over-optimism or pessimism is fueled when a surprise in price expectations is interpreted partially by the agents as a permanent change in the parameters governing the collateral price process and is validated by subsequently realized prices. I show that the model can quantitatively account for the recent US boom-bust cycle in house prices, household debt and aggregate consumption dynamics during 2001-2008. I also demonstrate that the leveraged economy with a higher steady state leverage ratio is more prone to self-reinforcing learning dynamics.

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    Paper provided by Department of Economics, University of Birmingham in its series Discussion Papers with number 13-02.

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    Length: 45 pages
    Date of creation: Jan 2013
    Date of revision:
    Handle: RePEc:bir:birmec:13-02
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    Edgbaston, Birmingham, B15 2TT

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    1. Tiziana Assenzay & Michele Berardi, 2008. "Learning in a Credit Economy," Centre for Growth and Business Cycle Research Discussion Paper Series 100, Economics, The Univeristy of Manchester.
    2. Zheng Liu & Pengfei Wang & Tao Zha, 2011. "Land-price dynamics and macroeconomic fluctuations," NBER Working Papers 17045, National Bureau of Economic Research, Inc.
    3. Kiyotaki, Nobuhiro & Moore, John, 1997. "Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 211-48, April.
    4. Eva Carceles-Poveda & Chryssi Giannitsarou, 2008. "Asset Pricing with Adaptive Learning," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(3), pages 629-651, July.
    5. Klaus Adam & Albert Marcet, 2010. "Booms and Busts in Asset Prices," IMES Discussion Paper Series 10-E-02, Institute for Monetary and Economic Studies, Bank of Japan.
    6. Juan-Carlos Cordoba & Marla Ripoll, 2004. "Credit Cycles Redux," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(4), pages 1011-1046, November.
    7. Kevin X. D. Huang & Zheng Liu & Tao Zha, 2008. "Learning, adaptive expectations, and technology shocks," Working Paper Series 2008-18, Federal Reserve Bank of San Francisco.
    8. 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.
    9. Boz, Emine & Mendoza, Enrique G., 2014. "Financial innovation, the discovery of risk, and the U.S. credit crisis," Journal of Monetary Economics, Elsevier, vol. 62(C), pages 1-22.
    10. Matteo Iacoviello, 2005. "House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle," American Economic Review, American Economic Association, vol. 95(3), pages 739-764, June.
    11. Klaus Adam & Pei Kuang & Albert Marcet, 2011. "House Price Booms and the Current Account," CEP Discussion Papers dp1064, Centre for Economic Performance, LSE.
    12. Simeon Djankov & Oliver Hart & Caralee McLiesh & Andrei Shleifer, 2006. "Debt Enforcement Around the World," NBER Working Papers 12807, National Bureau of Economic Research, Inc.
    13. Klaus Adam & Albert Marcet, 2011. "Internal Rationality, Imperfect Market Knowledge and Asset Prices," CEP Discussion Papers dp1068, Centre for Economic Performance, LSE.
    14. Kevin J. Lansing, 2007. "Rational and near-rational bubbles without drift," Working Paper Series 2007-10, Federal Reserve Bank of San Francisco.
    15. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
    16. Matteo Iacoviello & Stefano Neri, 2010. "Housing Market Spillovers: Evidence from an Estimated DSGE Model," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(2), pages 125-64, April.
    17. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
    18. Stefano Eusepi & Bruce Preston, 2008. "Expectations, Learning and Business Cycle Fluctuations," NBER Working Papers 14181, National Bureau of Economic Research, Inc.
    19. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2016. "Stock Market Volatility and Learning," Journal of Finance, American Finance Association, vol. 71(1), pages 33-82, 02.
    20. John Y. Campbell, 1992. "Inspecting the Mechanism: An Analytical Approach to the Stochastic Growth Model," NBER Working Papers 4188, National Bureau of Economic Research, Inc.
    21. Kuang, Pei, 2016. "A Note On Learning In A Credit Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 20(03), pages 845-855, April.
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