Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment

Arvind Krishnamurthy and Wenhao Li
Additional contact information
Wenhao Li: U of Southern California

Research Papers from Stanford University, Graduate School of Business

Abstract: We develop a model of financial crises with both a financial amplification mecha- nism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. We confront the model with data on credit spreads, equity prices, credit, and output across the financial crisis cycle. In particular, we ask the model to match data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the post-crisis period characterized by a slow recovery in output. A pure amplification mechanism quantitatively matches the crisis and aftermath period but fails to match the pre-crisis evidence. Mixing sentiment and amplification allows the model to additionally match the pre-crisis evidence. We consider two versions of sentiment, a Bayesian belief updating process and one that overweighs recent observations. Both models match the crisis patterns qualitatively, while the non-Bayesian model better matches the pre-crisis froth quantitatively. Finally, we show that a lean-against-the-wind policy has a quantitatively similar impact in both versions of the belief model, indicating that policy need not condition on true beliefs.

Date: 2020-09
New Economics Papers: this item is included in nep-dge, nep-fdg, nep-ifn and nep-mon
References: Add references at CitEc
Citations: View citations in EconPapers (17)

Downloads: (external link)
https://www.gsb.stanford.edu/gsb-cmis/gsb-cmis-download-auth/498751
Our link check indicates that this URL is bad, the error code is: 404 Not Found

Related works:
Working Paper: Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment (2020)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ecl:stabus:3874

Access Statistics for this paper

More papers in Research Papers from Stanford University, Graduate School of Business Contact information at EDIRC.
Bibliographic data for series maintained by ().