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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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    File URL: ftp://ftp.bham.ac.uk/pub/RePEc/pdf/13-02.pdf
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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
    Contact details of provider: Postal: Edgbaston, Birmingham, B15 2TT
    Web page: http://www.economics.bham.ac.uk

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    18. Assenza, Tiziana & Berardi, Michele, 2009. "Learning in a credit economy," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1159-1169, May.
    19. Hart, Oliver & Moore, John, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 841-79, November.
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    22. Pei Kuang, 2013. "A Note on Learning in a Credit Economy," Discussion Papers 14-08, Department of Economics, University of Birmingham.
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