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A Model of Capital and Crises

  • Zhiguo He
  • Arvind Krishnamurthy
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    We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates.

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    File URL: http://www.nber.org/papers/w14366.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14366.

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    Date of creation: Sep 2008
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    Publication status: published as A Model of Capital and Crises, 2012, with Arvind Krishnamurthy, Review of Economic Studies 79(2): pp. 735-777. Presentation Slides.
    Handle: RePEc:nbr:nberwo:14366
    Note: AP CF
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