Macro-prudential Policy in a Fisherian Model of Financial Innovation; Monetary and Macroprudential Policies, Twelfth Jacques Polak Annual Research Conference; November 10—11, 2011

The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs are thought to have played a central role in the 2008 financial crisis. This paper lays out a quantitative general equilibrium macro framework in which this interaction drives the financial amplification mechanism and studies its implications for the design 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 the transition probabilities across states with high and low ability to borrow change as agents observe realizations of financial conditions, and in the long-run converge to the true probabilities. At the same time, the credit constraint that links debt to asset values introduces a pecuniary externality because agents fail to internalize the effect of their borrowing decisions on asset prices. The interaction between these forces strengthens the financial amplification mechanism, making macro-prudential policy more desirable. We show how the effectiveness of this policy depends on the government’s information set; the policy is weaker when the government is as uninformed about the riskiness of the new financial regime as private agents.