Financial innovation, macroeconomic stability and systemic crises

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 12 February 2008

Working Paper No. 340
By Prasanna Gai, Sujit Kapadia, Stephen Millard and Ander Perez

We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and captures the spillovers associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, these spillovers can potentially generate a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past, but potentially more severe.

PDFFinancial innovation, macroeconomic stability and systemic crises

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