Learning Financial Structural Change and the Great Recession∗

This paper develops a simple business-cycle model in which the financial sector originates a structural change that has large macroeconomic effects when private agents are gradually learning their economic environment. When the persistence of the unobserved process driving financial shocks to the leverage ratio changes, the responses of output and other aggregates under adaptive learning are significantly larger than under rational expectations. In our benchmark case calibrated using 2008Q4 data on leverage, debt-to-GDP and land value-to-GDP ratios, learning amplifies leverage shocks by a factor of about four, relative to rational expectations. In addition, we show that procyclical leverage reinforces the impact of learning and, accordingly, that macro-prudential policies enforcing countercyclical leverage promote stability. Finally, we illustrate both how learning with a misspecified model that ignores real/financial linkages also contributes to magnify financial shocks and how interest rate news shocks are propagated under learning with structural change.