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Imperfect Knowledge about Asset Prices and Credit Cycles

  • Pei Kuang

    ()

    (University of Birmingham)

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    I develop an equilibrium model with collateral constraints in which rational agents are uncertain and learn about the equilibrium mapping between fundamentals and collateral prices. Bayesian updating of beliefs by agents can endogenously generate booms and busts in collateral prices and largely strengthen the role of collateral constraints as an amplification mechanism through the interaction of agents?' beliefs, collateral prices and credit limits. Over-optimism or pessimism is fueled when a surprise in price expectations is interpreted partially by the agents as a permanent change in the parameters governing the collateral price process and is validated by subsequently realized prices. I show that the model can quantitatively account for the recent US boom-bust cycle in house prices, household debt and aggregate consumption dynamics during 2001-2008. I also demonstrate that the leveraged economy with a higher steady state leverage ratio is more prone to self-reinforcing learning dynamics.

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    File URL: http://www.st-andrews.ac.uk/economics/repecfiles/2/1303.pdf
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    Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 201303.

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    Date of creation: 01 Jan 2013
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    Handle: RePEc:san:cdmawp:1303
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