Reviewing the Leverage Cycle

Ana Fostel and John Geanakoplos ()
Additional contact information
Ana Fostel: Dept. of Economics, George Washington University
John Geanakoplos: Cowles Foundation, Yale University, https://economics.yale.edu/people/faculty/john-geanakoplos

No 1918, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices, and create bubbles. We show how leverage can be endogenously determined in equilibrium, and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the Leverage Cycle. We also describe some cross-sectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest quality debt. We explain the differences between the leverage cycle and the credit cycle literature. Finally, we describe an agent based model of the leverage cycle in which asset prices display clustered volatility and fat tails even though all the shocks are essentially Gaussian.

Keywords: Leverage; Leverage cycle; Volatility; Collateral equilibrium; Collateral value; Liquidity wedge; Flight to collateral; Contagion; Adverse selection; Agent based models (search for similar items in EconPapers)
JEL-codes: E32 E44 G01 G12 G14 G15 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2013-09
New Economics Papers: this item is included in nep-ban, nep-cta and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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