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'Growth and Business Cycle Effects of Future Financial Crises'

Detail Summary
Date 9 December 2014
Time 12:30 - 14:00

Abstract:

Abstract: I study the ex ante effects of the fear of future financial crises. I show theoretically that this “crisis fear” has both negative growth
and business cycle effects. Productive experts fund investment by issuing debt to less productive households in a model featuring both business cycle shocks and endogenous growth. Crises are modelled through multiple equilibria: in some states the experts’ net worth can
be wiped out by a self fulfilling fall in asset prices. I study the effects of allowing agents to anticipate such an event, by solving the model with a sunspot determining equilibrium selection. In a financial crisis, capital is pushed away from experts and towards less productive households, worsening the allocation of capital. Thus the possibility of future crises lowers the expected return on capital. This lowers asset prices and hence investment and growth today, even if experts are currently well enough capitalised to survive a crisis. The possibility of future crises also creates a state-dependent “financial crisis accelerator”: shocks which push the economy closer to crisis lead to more severe financial accelerator effects than those that push the economy away from crisis.