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

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  • Ms. Emine Boz
  • Mr. Enrique G. Mendoza

Abstract

Uncertainty about the riskiness of new financial products 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 a new financial environment. Early realizations of states with high ability to leverage assets into debt turn agents optimistic about the persistence of a high-leverage regime. The model accounts for 69 percent of the household debt buildup and 53 percent of the rise in housing prices during 1997-2006, predicting a collapse in 2007.

Suggested Citation

  • Ms. Emine Boz & Mr. Enrique G. Mendoza, 2010. "Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis," IMF Working Papers 2010/164, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:2010/164
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    References listed on IDEAS

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    More about this item

    Keywords

    WP; financial crisis; credit market;
    All these keywords.

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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