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Macro-prudential Policy in a Fisherian Model of Financial Innovation

Macro-prudential Policy in a Fisherian Model of Financial Innovation by Javier Bianchi
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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.
International Monetary Fund; July 2012
54 pages; ISBN 9781475570724
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Title: Macro-prudential Policy in a Fisherian Model of Financial Innovation
Author: Javier Bianchi; Emine Boz; Enrique G. Mendoza
 
ISBNs
1475570724
9781475505290
9781475570724
9781475576627