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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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File URL: http://www.nber.org/papers/w18036.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18036.

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Date of creation: May 2012
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Publication status: published as Javier Bianchi & Emine Boz & Enrique Gabriel Mendoza, 2012. "Macroprudential Policy in a Fisherian Model of Financial Innovation," IMF Economic Review, Palgrave Macmillan, vol. 60(2), pages 223-269, July.
Handle: RePEc:nbr:nberwo:18036
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  1. Enrique G. Mendoza & Marco E. Terrones, 2008. "An anatomy of credit booms: evidence from macro aggregates and micro data," International Finance Discussion Papers 936, Board of Governors of the Federal Reserve System (U.S.).
  2. Boz, Emine & Mendoza, Enrique G., 2014. "Financial innovation, the discovery of risk, and the U.S. credit crisis," Journal of Monetary Economics, Elsevier, vol. 62(C), pages 1-22.
  3. 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.).
  4. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute.
  5. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  6. Gennaioli, N. & Shleifer, Andrei, 2010. "What Comes to Mind," Scholarly Articles 27867129, Harvard University Department of Economics.
  7. Gennaioli, Nicola & Shleifer, Andrei & Vishny, Robert, 2012. "Neglected Risks, Financial Innovation, and Financial Fragility," Scholarly Articles 10886835, Harvard University Department of Economics.
  8. Javier Bianchi, 2010. "Overborrowing and Systemic Externalities in the Business Cycle," 2010 Meeting Papers 96, Society for Economic Dynamics.
  9. Enrique G. Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  10. Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
  11. 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.
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