Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment / Arvind Krishnamurthy, Wenhao Li.

Format:

Book

Author/Creator:

Krishnamurthy, Arvind.

Contributor:

National Bureau of Economic Research.

Li, Wenhao.

Series:

Working Paper Series (National Bureau of Economic Research) no. w27088.

NBER working paper series no. w27088

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2020.

Summary:

We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. We confront the model with data on credit spreads, equity prices, credit, and output across the financial crisis cycle. In particular, we ask the model to match data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the post-crisis period characterized by a slow recovery in output. Our model with the frictional intermediation mechanism and fluctuations in beliefs provides a parsimonious account of the entire crisis cycle. The model with only the frictional intermediation mechanism misses the frothy pre-crisis behavior; fluctuations in beliefs resolve this problem. On the other hand, modeling the belief variation via either a Bayesian or diagnostic model match the broad patterns, with each missing some targets to different extents. We also show that a lean-against-the-wind policy has a quantitatively similar impact in both versions of the belief model, indicating that policy need not "get into the minds" of investors and condition on the true belief process.

Notes:

Print version record

May 2020.