Macroprudential Policy in a Fisherian Model of Financial Innovation

Javier Bianchi, Emine Boz and Enrique Mendoza

IMF Economic Review, 2012, vol. 60, issue 2, 223-269

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 macroprudential 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 macroprudential 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.

Date: 2012
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Working Paper: Macro-prudential 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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