Learning Leverage Shocks and the Great Recession

Patrick Pintus and Jacek Suda

Working papers from Banque de France

Abstract: This paper develops a simple business-cycle model in which financial shocks have large macroeconomic effects when private agents are gradually learning their economic environment. When agents update their beliefs about the unobserved process driving financial shocks to the leverage ratio, the responses of output and other aggregates under adaptive learning are significantly larger than under rational expectations. In our benchmark case calibrated using US data on leverage, debt-to-GDP and land value-to-GDP ratios for 1996Q1-2008Q4, learning amplifies leverage shocks by a factor of about three, relative to rational expectations. When fed with the actual leverage innovations, the learning model predicts the correct magnitude for the Great Recession, while its rational expectations counterpart predicts a counter-factual expansion. In addition, we show that procyclical leverage reinforces the impact of learning and, accordingly, that macro-prudential policies enforcing countercyclical leverage dampen the effects of leverage shocks. Finally, we illustrate how learning with a misspecified model that ignores real/financial linkages also contributes to magnify financial shocks.

Keywords: Borrowing Constraints; Collateral; Leverage; Learning; Financial Shocks; Recession (search for similar items in EconPapers)
JEL-codes: E32 E44 G18 (search for similar items in EconPapers)
Pages: 55 pages
Date: 2013
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac, nep-opm and nep-spo
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:bfr:banfra:440

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