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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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    1. Stefano Eusepi & Bruce Preston, 2011. "Expectations, Learning, and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 101(6), pages 2844-72, October.
    2. Oliver Hart & John Moore, 1991. "A Theory of Debt Based on the Inalienability of Human Capital," NBER Working Papers 3906, National Bureau of Economic Research, Inc.
    3. pengfei Wang & Tao Zha & Zheng Liu, 2012. "Land-Price Dynamics and Macroeconomic Fluctuations," 2012 Meeting Papers 85, Society for Economic Dynamics.
    4. Assenza, Tiziana & Berardi, Michele, 2009. "Learning in a credit economy," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1159-1169, May.
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    7. Campbell, John Y., 1994. "Inspecting the mechanism: An analytical approach to the stochastic growth model," Journal of Monetary Economics, Elsevier, vol. 33(3), pages 463-506, June.
    8. Klaus Adam & Pei Kuang & Albert Marcet, 2011. "House Price Booms and the Current Account," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 77-122 National Bureau of Economic Research, Inc.
    9. Matteo Iacoviello & Stefano Neri, 2008. "Housing market spillovers: Evidence from an estimated DSGE model," Temi di discussione (Economic working papers) 659, Bank of Italy, Economic Research and International Relations Area.
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    11. Adam, Klaus & Marcet, Albert & Nicolini, Juan Pablo, 2015. "Stock Market Volatility and Learning," Working Papers 720, Federal Reserve Bank of Minneapolis.
    12. Pei Kuang, 2013. "A Note on Learning in a Credit Economy," Discussion Papers 14-08, Department of Economics, University of Birmingham.
    13. Kevin J. Lansing, 2007. "Rational and Near-Rational Bubbles Without Drift," 2007 Meeting Papers 970, Society for Economic Dynamics.
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    15. Milani, Fabio, 2010. "Expectation Shocks and Learning as Drivers of the Business Cycle," CEPR Discussion Papers 7743, C.E.P.R. Discussion Papers.
    16. Enrique G. Mendoza & Emine Boz, 2010. "Financial innovation, the Discovery of Risk, and the U.S. Credit Crisis," IMF Working Papers 10/164, International Monetary Fund.
    17. 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.
    18. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
    19. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
    20. Klaus Adam & Albert Marcet, 2011. "Internal Rationality, Imperfect Market Knowledge and Asset Prices," CEP Discussion Papers dp1068, Centre for Economic Performance, LSE.
    21. Andrea Ferrero, 2011. "House Prices Booms and Current Account Deficits," 2011 Meeting Papers 1386, Society for Economic Dynamics.
    22. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
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