Journal of Monetary Economics2013-09-05 2:57 AM

An expectations-driven interpretation of the “Great Recession”

Highlights • We link the boom that preceded the "Great Recession" and the eventual bust together. • Expected gains from financial innovations may have been too optimistic. • We use a financial-accelerator framework in a real DGE model to study news-shocks. • Changes in expectations about future default costs generate a boom-bust cycle. • A boom in asset prices and leverage, accompany a countercyclical credit spread. Abstract The boom-years preceding the “great recession” were a time of rapid innovation in the financial industry. We explore the idea that both the boom and eventual bust emerged from overoptimistic expectations of efficiency-gains in the financial sector. We treat the bankruptcy costs facing intermediaries in a costly state verification problem as a stochastic process, and model the boom-bust in terms of an unfulfilled news-shock where the expected fall in costs are eventually not realized. In response to a change in expectations only, the model generates a boom-bust cycle in aggregate activity, asset prices and leverage, and a countercyclical credit spread.

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Journal of Monetary Economics

The Journal of Monetary Economics is a peer-reviewed academic journal covering research on macroeconomics and monetary economics. It is published by Elsevier and was established in October 1973 by Karl Brunner and Charles I. Plosser.

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