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Ambiguity attitudes and the leverage cycle

Marzio Bassanin, Ester Faia () and Valeria Patella ()

Journal of International Economics, 2021, vol. 129, issue C

Abstract: Financial crises originate in debt markets, where beliefs formation about asset values affects the value of collateral, hence the leverage cycles. We introduce novel state-contingent ambiguity attitudes, which endogenously induce pessimism in recessions and optimism in booms, in a model with occasionally binding collateral constraints and exogenous debt supply. Ambiguity is measured in the data through GMM estimation of the Euler equations, and delivers over-extrapolative behaviors through forecasters' beliefs' wedges and forecast errors. Analytically and numerically (global methods), it is shown that the model explains asset price and debt cycle facts. Optimism heightens the build-up of debt and asset prices prior to a crisis event and enhances leverage pro-cyclicality; pessimism heightens the de-leveraging following it.

Keywords: Ambiguity attitudes; Occasionally binding constraints; Kinked beliefs; Leverage cycle; Optimism and pessimism; Sudden reversals (search for similar items in EconPapers)
JEL-codes: D8 E21 E32 E44 F34 G01 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jinteco.2021.103436

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