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The Allocation of Aggregate Risk, Secondary Market Trades, and Financial Boom–Bust Cycles
Author(s) -
BEAUDRY PAUL,
LAHIRI AMARTYA
Publication year - 2014
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/jmcb.12096
Subject(s) - collateralized debt obligation , recession , bust , debt , systematic risk , economics , monetary economics , financial market , risk premium , systemic risk , financial accelerator , financial crisis , boom , collateral , finance , monetary policy , macroeconomics , dynamic stochastic general equilibrium , environmental engineering , engineering
The financial crisis of 2007–08 started with the collapse of the market for collateralized debt obligations backed by subprime mortgages. In this paper we present a mechanism aimed at explaining how a freeze in a secondary debt market can be amplified and propagated to the real economy, and thereby cause a recession. Moreover, we show why such a process is likely to be especially strong after a prolonged expansion based on the growth of consumer credit and endogenously low risk premia. Hence, our model offers a new perspective on the links between the real and financial sectors, and we show how it can help make sense of several macro‐economic features of the 2001–09 period. The key elements of the model are heterogeneity across agents in terms of risk tolerance, a financial sector that allocates systematic risk efficiently across agents, and real decisions that depend on the price of risk.