Macro-prudential Policy in a Fisherian Model of Financial Innovation

By Javier Bianchi, Emine Boz, Enrique G. Mendoza

July 1, 2012

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Javier Bianchi, Emine Boz, and Enrique G. Mendoza Macro-prudential Policy in a Fisherian Model of Financial Innovation, (USA: International Monetary Fund, 2012) accessed November 21, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Asset prices, Collateral, Credit, Financial institutions, Land prices, Money, Prices, Revenue administration, Tax arrears management

Keywords: Asset price, Asset prices, Bayesian learning, Collateral, Collateral constraint, Credit, Credit market, Debt position, Debt tax, Financial crises, Financial innovation, Global, Investment volatility, Land price, Land prices, Macro-prudential policy, Macro-prudential regulation, Pecuniary externality, Pricing function, Tax arrears management, WP

Publication Details

Pages:

54
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2012/181
Stock No:

WPIEA2012181
ISBN:

9781475505290
ISSN:

1018-5941

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