Macro-prudential Policy in a Neo-Fisherian Model of Financial Innovation∗

The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs is thought to have played a central role in the 2008 financial crisis. This paper uses a quantitative general equilibrium framework in which this interaction drives the financial amplification mechanism to study 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 the transition probabilities across states with high and low ability to borrow change as agents learn from the 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. The interaction of learning and credit frictions strengthens the financial amplification mechanism, making macro-prudential policy more desirable. Quantitative analysis shows that the effectiveness of this policy 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. Macro-prudential policy is effective except when the government is as uninformed as private agents, credit constraints are tight, and optimism builds quickly.