IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this paper or follow this series

Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis

  • Boz, Emine
  • Mendoza, Enrique G

Uncertainty about the riskiness of a new financial environment was an important factor behind the U.S. credit crisis. We show that a boom-bust cycle in debt, asset prices and consumption characterizes the equilibrium dynamics of a model with a collateral constraint in which agents learn "by observation" the true riskiness of the new environment. Early realizations of states with high ability to leverage assets into debt turn agents overly optimistic about the probability of persistence of a high-leverage regime. Conversely, the first realization of the low-leverage state turns agents unduly pessimistic about future credit prospects. These effects interact with the Fisherian deflation mechanism, resulting in changes in debt, leverage, and asset prices larger than predicted under either rational expectations without learning or with learning but without Fisherian de°ation. The model can account for 69 percent of the rise in net household debt and 53 percent of the rise in residential land prices between 1997 and 2006, and it predicts a sharp collapse in 2007.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=7967
Download Restriction: CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7967.

as
in new window

Length:
Date of creation: Aug 2010
Date of revision:
Handle: RePEc:cpr:ceprdp:7967
Contact details of provider: Postal: Centre for Economic Policy Research, 77 Bastwick Street, London EC1V 3PZ.
Phone: 44 - 20 - 7183 8801
Fax: 44 - 20 - 7183 8820

Order Information: Email:


References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Javier Bianchi, 2011. "Overborrowing and Systemic Externalities in the Business Cycle," American Economic Review, American Economic Association, vol. 101(7), pages 3400-3426, December.
  2. Timothy Cogley & Thomas J. Sargent, 2008. "Anticipated Utility And Rational Expectations As Approximations Of Bayesian Decision Making," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(1), pages 185-221, 02.
  3. Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, vol. 70(1), pages 82-114, September.
  4. Gertler, Mark & Kiyotaki, Nobuhiro, 2010. "Financial Intermediation and Credit Policy in Business Cycle Analysis," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 11, pages 547-599 Elsevier.
  5. Jack Favilukis & Sydney C. Ludvigson & Stijn Van Nieuwerburgh, 2010. "The Macroeconomic Effects of Housing Wealth, Housing Finance, and Limited Risk-Sharing in General Equilibrium," NBER Working Papers 15988, National Bureau of Economic Research, Inc.
  6. Zeira, Joseph, 1993. "Informational Overshooting, Booms and Crashes," CEPR Discussion Papers 823, C.E.P.R. Discussion Papers.
  7. Klaus Adam & Pei Kuang & Albert Marcet, 2011. "House Price Booms and the Current Account," NBER Working Papers 17224, National Bureau of Economic Research, Inc.
  8. Emine Boz, 2007. "Can Miracles Lead to Crises? the Role of Optimism in Emerging Markets Crises," IMF Working Papers 07/223, International Monetary Fund.
  9. Jermann, Urban & Quadrini, Vincenzo, 2006. "Financial Innovations and Macroeconomic Volatility," CEPR Discussion Papers 5727, C.E.P.R. Discussion Papers.
  10. Francis E. Warnock & Veronica C. Warnock, 2005. "International capital flows and U.S. interest rates," International Finance Discussion Papers 840, Board of Governors of the Federal Reserve System (U.S.).
  11. Kiyotaki, Nobuhiro & Michaelides, Alexander & Nikolov, Kalin, 2010. "Winners and Losers in Housing Markets," CEPR Discussion Papers 7953, C.E.P.R. Discussion Papers.
  12. Mendoza, Enrique G. & Quadrini, Vincenzo, 2010. "Financial globalization, financial crises and contagion," Journal of Monetary Economics, Elsevier, vol. 57(1), pages 24-39, January.
  13. Morris A. Davis & Jonathan Heathcote, 2004. "The price and quantity of residential land in the United States," Finance and Economics Discussion Series 2004-37, Board of Governors of the Federal Reserve System (U.S.).
  14. Nicola Gennaioli & Andrei Shleifer & Robert W. Vishny, 2010. "Neglected Risks, Financial Innovation, and Financial Fragility," NBER Working Papers 16068, National Bureau of Economic Research, Inc.
  15. Enrique G. Mendoza & Marco E. Terrones, 2012. "An Anatomy of Credit Booms and their Demise," NBER Working Papers 18379, National Bureau of Economic Research, Inc.
  16. Guido Lorenzoni, 2009. "A Theory of Demand Shocks," American Economic Review, American Economic Association, vol. 99(5), pages 2050-84, December.
  17. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
  18. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2004. "Learning and shifts in long-run productivity growth," Finance and Economics Discussion Series 2004-21, Board of Governors of the Federal Reserve System (U.S.).
  19. Evans, George W. & Honkapohja, Seppo, 1999. "Learning dynamics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 7, pages 449-542 Elsevier.
  20. Enrique G. Mendoza & Vincenzo Quadrini & José-Víctor Ríos-Rull, 2009. "Financial Integration, Financial Development, and Global Imbalances," Journal of Political Economy, University of Chicago Press, vol. 117(3), pages 371-416, 06.
  21. Ceyhun Bora Durdu & Enrique G. Mendoza & Marco E. Terrones, 2007. "Precautionary demand for foreign assets in sudden stop economies: an assessment of the new mercantilism," International Finance Discussion Papers 911, Board of Governors of the Federal Reserve System (U.S.).
  22. Boz, Emine & Daude, Christian & Bora Durdu, C., 2011. "Emerging market business cycles: Learning about the trend," Journal of Monetary Economics, Elsevier, vol. 58(6), pages 616-631.
  23. Campbell, Jeffrey R. & Hercowitz, Zvi, 2009. "Welfare implications of the transition to high household debt," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 1-16, January.
  24. Cogley, Timothy & Sargent, Thomas J., 2008. "The market price of risk and the equity premium: A legacy of the Great Depression?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 454-476, April.
  25. Laura Veldkamp, 2003. "Learning Asymmetries in Real Business Cycles," Working Papers 03-21, New York University, Leonard N. Stern School of Business, Department of Economics.
  26. Javier Bianchi & Emine Boz & Enrique G. Mendoza, 2012. "Macro-prudential Policy in a Fisherian Model of Financial Innovation," IMF Working Papers 12/181, International Monetary Fund.
  27. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973, April.
  28. Andrea Ferrero, 2012. "House price booms, current account deficits, and low interest rates," Staff Reports 541, Federal Reserve Bank of New York.
  29. Emine Boz & Christian Daude & Ceyhun Bora Durdu, 2008. "Emerging market business cycles revisited: learning about the trend," International Finance Discussion Papers 927, Board of Governors of the Federal Reserve System (U.S.).
  30. Enrique G. Mendoza, 2010. "Sudden Stops, Financial Crises, and Leverage," American Economic Review, American Economic Association, vol. 100(5), pages 1941-66, December.
  31. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:7967. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.