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Financial innovation, macroeconomic stability and systemic crises

  • Prasanna Gai
  • Sujit Kapadia
  • Stephen Millard
  • Ander Perez

We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and captures the spillovers associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, these spillovers can potentially generate a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past, but potentially more severe.

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Paper provided by Bank of England in its series Bank of England working papers with number 340.

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Date of creation: Feb 2008
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Handle: RePEc:boe:boeewp:340
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