Financial Innovation, Macroeconomic Stability and Systemic Crisis

Prasanna Gai, Sujit Kapadia, Stephen Millard, Ander Perez

    Research output: Contribution to journalArticle

    Abstract

    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 contains a clearly defined pecuniary externality associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, this externality is capable of generating 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.
    Original languageEnglish
    Pages (from-to)401-426
    JournalThe Economic Journal
    Volume118
    Issue number527
    DOIs
    Publication statusPublished - 2008

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