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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. Davis, Morris & Heathcote, Jonathan, 2005. "The Price and Quantity of Residential Land in the United States," CEPR Discussion Papers 5333, C.E.P.R. Discussion Papers.
  2. Nicola Gennaioli & Andrei Shleifer, 2009. "What comes to mind," Economics Working Papers 1186, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2009.
  3. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2010. "Financial Crises and Macro-Prudential Policies," CEP Discussion Papers dp1032, Centre for Economic Performance, LSE.
  4. Enrique Mendoza & Emine Boz, 2010. "Financial Innovation, the Discovery of Risk, and the U.S. Credit Crisis," 2010 Meeting Papers 316, Society for Economic Dynamics.
  5. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  6. Marco Terrones & Enrique G. Mendoza, 2008. "An Anatomy of Credit Booms; Evidence From Macro Aggregates and Micro Data," IMF Working Papers 08/226, International Monetary Fund.
  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. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  9. Nicola Gennaioli & Andrei Shleifer & Robert Vishny, 2010. "Neglected risks, financial innovation and financial fragility," Economics Working Papers 1251, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2010.
  10. Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
  11. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute.
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