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Risk Allocation, Debt Fueled Expansion and Financial Crisis

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  • Paul Beaudry
  • Amartya Lahiri

Abstract

In this paper we discuss how several macroeconomic features of the 2001-2009 period may have resulted from a process in which financial markets were trying to allocate risk between heterogeneous agents when productive investment opportunities are scarce. We begin by showing how heterogeneity in terms of risk tolerance can cause financial markets to propagate transitory shocks and induce higher output volatility, albeit with a higher mean. We then show how this simple heterogeneous agent framework can explain an expansion driven by the growth in consumer debt, and why the equilibrium path of such an economy is likely fragile. In particular, we demonstrate that the emergence of a small amount of asymmetric information can make the economy susceptible to changes in expectations that can induce large reversals of financial flows, the freezing of assets and a recession that can persist despite high productivity.

Suggested Citation

  • Paul Beaudry & Amartya Lahiri, 2009. "Risk Allocation, Debt Fueled Expansion and Financial Crisis," NBER Working Papers 15110, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:15110
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    File URL: http://www.nber.org/papers/w15110.pdf
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    1. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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    Cited by:

    1. Gunn, Christopher M. & Johri, Alok, 2013. "An expectations-driven interpretation of the “Great Recession”," Journal of Monetary Economics, Elsevier, vol. 60(4), pages 391-407.
    2. Eric van Wincoop & Cedric Tille & Philippe Bacchetta, 2010. "On the Dynamics of Leverage, Liquidity, and Risk," 2010 Meeting Papers 393, Society for Economic Dynamics.
    3. Christopher M. Gunn & Alok Johri, 2012. "News, Credit Spreads and Default Costs: An expectations-driven interpretation of the recent boom-bust cycle in the U.S," Department of Economics Working Papers 2012-04, McMaster University.

    More about this item

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • G01 - Financial Economics - - General - - - Financial Crises

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