Financial Innovation, Macroeconomic Stability and Systemic Crises

Prasanna Gai, Sujit Kapadia, Stephen Millard and Ander Perez

Economic Journal, 2008, vol. 118, issue 527, 401-426

Abstract: We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and contains a clearly defined pecuniary externality associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, this externality is capable of generating a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past but potentially more severe. Copyright © Bank of England.

Date: 2008
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Related works:
Journal Article: Financial Innovation, Macroeconomic Stability and Systemic Crises (2008)
Working Paper: Financial innovation, macroeconomic stability and systemic crises (2008)
Journal Article: Financial innovation, macroeconomic stability and systemic crises (2006)
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