Macro-Prudential Policy in a Fisherian model of Financial Innovation

Javier Bianchi, Emine Boz and Enrique Mendoza

No 18036, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: D62 D82 E32 E44 F32 F41 (search for similar items in EconPapers)
Date: 2012-05
New Economics Papers: this item is included in nep-ban, nep-cba and nep-dge
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

Published as Javier Bianchi & Emine Boz & Enrique Gabriel Mendoza, 2012. "Macroprudential Policy in a Fisherian Model of Financial Innovation," IMF Economic Review, Palgrave Macmillan, vol. 60(2), pages 223-269, July.
Published as Javier Bianchi & Emine Boz & Enrique G. Mendoza, 2012. "Macro-prudential Policy in a Fisherian Model of Financial Innovation," IMF Working Papers, vol 12(181).

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Journal Article: Macroprudential Policy in a Fisherian Model of Financial Innovation (2012)
Working Paper: Macro-prudential Policy in a Fisherian Model of Financial Innovation (2012)
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