Wednesday, November 16, 2011

New working paper (ls)

I'm going for some shameless self-promotion. fg and I wrote a working paper where we have set up a macro-finance model, in which policymakers have to deal with endogenously arising boom-bust cycles on financial markets and their real-economy impact. It can be downloaded here.


We merge a financial market model with leverage-constrained, heterogeneous agents with a reduced-form version of the New-Keynesian standard model. Agents in both submodels are assumed to be boundedly rational. The financial market model produces endogenously arising boom-bust cycles. It is also capable to generate highly non-linear deleveraging processes, fire sales and ultimately a default scenario. Asset price booms are triggered via self-ful filling prophecies. Asset price busts are induced by agents' choice of an increasingly fragile balance sheet structure during good times. Their vulnerability is inevitably revealed by small, randomly occurring shocks. Our transmission channel of fi nancial market activity to the real sector embraces a recent strand of literature shedding light on the link between the active balance sheet management of nancial market participants, the induced procyclical fluctuations of desired risk compensations and their final impact on the real economy. We show that a systematic central bank reaction on financial market developments dampens macroeconomic volatility considerably. Furthermore, restricting leverage in a countercyclical fashion limits the magnitude of fi nancial cycles and hence their impact on the real economy.
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