Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment

Arvind Krishnamurthy and Wenhao Li

Journal of Political Economy, 2025, vol. 133, issue 3, 935 - 985

Abstract: We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. The model accounts for the entire crisis cycle, matching data on the frothy precrisis behavior of asset markets and credit; the sharp transition to a crisis where asset values fall, disintermediation occurs, and output falls; and the slow postcrisis recovery in output. Both the intermediation and the belief mechanism are essential to match the crisis cycle. However, modeling the belief variation via either a Bayesian or a diagnostic model can match the broad patterns.

Date: 2025
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