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Macro-prudential Policy in a Fisherian Model of Financial Innovation

  • Javier Bianchi
  • Emine Boz
  • Enrique G. Mendoza

The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs played a central role in the 2008 financial crisis. This paper develops a quantitative general equilibrium framework in which this interaction drives the financial amplification mechanism to study the effects of macro-prudential policy. Financial innovation enhances the ability of agents to collateralize assets into debt, but the riskiness of this new regime can only be learned over time. Beliefs about transition probabilities across states with high and low ability to borrow change as agents learn from observed realizations of financial conditions. At the same time, the collateral constraint introduces a pecuniary externality, because agents fail to internalize the effect of their borrowing decisions on asset prices. Quantitative analysis shows that the effectiveness of macro-prudential policy in this environment depends on the government's information set, the tightness of credit constraints and the pace at which optimism surges in the early stages of financial innovation. The policy is least effective when the government is as uninformed as private agents, credit constraints are tight, and optimism builds quickly.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 12/181.

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Length: 54
Date of creation: 01 Jul 2012
Date of revision:
Handle: RePEc:imf:imfwpa:12/181
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  1. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  2. 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.
  3. Boz, Emine & Mendoza, Enrique G, 2010. "Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis," CEPR Discussion Papers 7967, C.E.P.R. Discussion Papers.
  4. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2011. "Financial Crises and Macro-Prudential Policies," IDB Publications (Working Papers) 27738, Inter-American Development Bank.
  5. Enrique G. Mendoza & Marco E. Terrones, 2008. "An Anatomy Of Credit Booms: Evidence From Macro Aggregates And Micro Data," NBER Working Papers 14049, National Bureau of Economic Research, Inc.
  6. Nicola Gennaioli & Andrei Shleifer, 2009. "What Comes to Mind," NBER Working Papers 15084, National Bureau of Economic Research, Inc.
  7. Javier Bianchi, 2011. "Overborrowing and Systemic Externalities in the Business Cycle," American Economic Review, American Economic Association, vol. 101(7), pages 3400-3426, December.
  8. Jonathan Heathcote & Morris Davis, 2004. "The Price and Quantity of Residential Land in the United States," 2004 Meeting Papers 32, Society for Economic Dynamics.
  9. Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
  10. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  11. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute.
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