Financial fragility and economic fluctuations

This paper contrasts the Efficient Markets Hypothesis with Hyman Minsky's Financial Instability Hypothesis (FIH), taking into account the dynamic complexity of financial markets. This approach offers analytical tools that can account for crisis through processes endogenous to contemporary economies. Recent work, notably by J. Barkley Rosser, has suggested that complex dynamics is a strong foundations for Keynesian models and results. Group dynamics enter into the analysis in at least two ways: they provide an independent source of fundamental uncertainty which, as discussed by Keynes himself, can lead to speculative bubbles in asset markets, and they can cause overreactions in both lenders' and borrowers' attitudes toward risk. These aspects can lead to financial fragility and instability following a variety of complex dynamics. I shall argue that a financially complex system is, according to the FIH, inherently flawed and unstable: in the absence of adequate economic policy boom and bust phenomena, in financial markets which are fuelled by credit booms and busts, may generate endogenous instability and systemic crisis, such as the recent sub-prime mortgage crisis.

Journal of Mathematical Economics, 2003

Cambridge Journal of Economics, 2011

The paper examines three aspects of a financial crisis of domestic origin. The first section studies the evolution of a debt-financed consumption boom supported by rising asset prices, leading to a credit crunch and fluctuations in the real economy, and, ultimately, to debt deflation. The next section extends the analysis to trace gradual evolution toward Ponzi finance and its consequences. The final section explains the link between the financial and the real sector of the economy, pointing to an inherent liquidity problem. The paper concludes with comments on the interactions between the three aspects.

Journal of Economic Theory, 2001

This paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects' operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crisis can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.

Journal of Financial Stability, 2004

The purpose of our work is to explore contagious financial crises. To this end, we use simplified, thus numerically solvable, versions of our general model ]. The model incorporates heterogeneous agents, banks and endogenous default, thus allowing various feedback and contagion channels to operate in equilibrium.

Journal of Economic Dynamics and Control, 2015

Within a general equilibrium framework à la , we investigate the dynamics emerging from the interactions of households and firms that are adaptive price setters and financially constrained. Adaptive price-setting behavior induces microfounded out-of-equilibrium dynamics along which agents become heterogeneous in terms of prices and wealth. The stringency of the financial constraints determines the regime into which the model settles: either an equilibrium one or a disequilibrium one conductive to financial fragility and aggregate volatility. In this setting, we investigate how the structure of the production network affects the emergence of aggregate volatility from micro-level price and financial shocks, hence providing a dynamical counterpart to recent results of . assumed to take place instantaneously to a framework where convergence to or divergence from equilibrium is determined endogenously. The efforts of general equilibrium theory in that direction were based on centralized price adjustment processes and almost entirely stopped by the impossibility results put forward in the Sonnenschein-Mantel-Debreu theorem. We take here a different route and use agent-based modeling to generate out-of-equilibrium dynamics via the simulation of the interactions of boundedly rational and heterogeneous agents (see , for an introduction to agent-based modeling).

The social role of any company is to get the maximum profitability with the less risk. Due to Basel III, banks should now raise their minimum capital levels on an individual basis, with the aim of lowering the probability for a large crash to occur. Such implementation assumes that with higher minimum capital levels it becomes more probable that the value of the assets drop bellow the minimum level and consequently expects the number of bank defaults to drop also. We present evidence that in such new financial reality large crashes are avoid only if one assumes that banks will accept quietly the drop of business levels, which is counter-nature. Our perspective steams from statistical physics and gives hints for improving bank system resilience. Stock markets exhibit critical behavior and scaling features, showing a power-law for the amplitude of financial crisis. By modeling a financial network where critical behavior naturally emerges it is possible to show that bank system resilie...

The standard model of currency crises is amended to distinguish between unemployment aversion and financial fragility. Fragility is assumed to affect the authorities' sensitivity to a combination of high real interest rates and unemployment. An increase in fragility expands the region of potentially self-fulfilling crises at the expense of the "safe" region, particularly if the fundamentals are weak. Although exposure to foreign exchange losses and dependence on the exchange rate as a nominal anchor both raise the cost of (and resistance to) devaluation, this has relatively little effect in the presence of financial fragility and poor fundamentals.

Federal Reserve Bank of San Francisco, Working Paper Series

Financial crises occur out of prolonged and credit-fueled boom periods and, at times, they are initiated by relatively small shocks that can have large effects. Consistent with these empirical observations, this paper extends a standard macroeconomic model to include financial intermediation, long-term loans, and occasional financial crises. Within this framework, intermediaries raise their lending and leverage in good times, thereby building up financial fragility. Crises typically occur at the end of a prolonged boom, initiated by a moderate adverse shock that triggers a liquidation of existing investment, a contraction in lending, and ultimately a deep and persistent recession.

We augment a standard monetary DSGE model to include financial markets, and fit the model to EA and US data. The empirical results draw attention to a new shock - a 'risk shock' to entrepreneurs - and to an important new nominal rigidity. The risk shock originates in the financial sector and accounts for a significant portion of business cycle fluctuations. We do a detailed study of the role of this shock in the boom-bust of the late 1990s and early 2000s. The new nominal friction corresponds to the fact that lending contracts are typically denominated in nominal terms. Consistent with Fisher (1933), we show that the distributional consequences of this nominal rigidity play an important role in the propagation of shocks.

This article seeks to provide a categorisation of events of systemic financial instability that have been experienced in recent decades, seeking to draw out common elements from these seemingly-diverse events. We maintain that despite the apparent diversity of events of financial instability, a useful summary categorisation is between bank, market-price and market-liquidity based crises. There are important subcategories of each type, such as domestic versus international, currency crisis linked, single-institution based, equity-related, property, commodities, deregulation and disintermediation linked crises. Such financial crises are usefully examined in the light of the theories of financial instability, not least to illuminate common generic patterns that can be helpful in macroprudential surveillance. We derive a framework for analysing the evolution of such crises, highlighting that it is vulnerability of a financial system that is the key common element to a crisis, besides the nature of propagation of a crisis to the wider economy. Besides having general applicability, notably to OECD countries, the typology and generic features have some relevant implications for euro area countries. Development of securities markets, the likelihood of regional crises and the likely impact of ageing are among aspects that warrant vigilance by policy makers in the euro zone.

2008

The links between aggregate financial indicators and business fluctuations have been widely addressed in literature while the same interest has not been devoted to the role of microeconomic financial variables in determining macroeconomic results. One of the causes may be individuated in the lack of suitable analytical tools. Firms are different each other as regards, at least, financial structure and size. Therefore, their responses to shocks come out to be different and asymmetric. Moreover, firms are reciprocally linked, and their diverse reactions influence the whole system at micro, macro and meso level. The uncertainty about the final outcome is amplified by feedback effects from aggregate level to firms. In this work we model an economic system populated by heterogeneous firms that, reacting to stochastic shocks to maximize their profit, modify the ratio among liabilities and equities. These variations influence the financial environment and the * demography of firms population, endogenously generating business fluctuations. Using a stochastic aggregation method we define a system of coupled dynamic equations that describe long run path and cycles of aggregate output.

2003

In this paper, we model an agent-based economy in which heterogeneous agents (firms and a bank) interact in the financial markets. The heterogeneity is due to the balance sheet conditions and to size. In our simulations, at the aggregate level, output displays changes in trend and volatility giving rise to complex dynamics. The average solvency and liquidity ratios peak during recessions as empirical analysis shows. At the firm level the model generates: i) firm sizes left-skewed distributed, ii) growth rates Laplace distributed. Furthermore, small idiosyncratic shocks can generate large aggregate fluctuations.

The paper sets up a model of economic crisis by investigating the role played by movement in asset price as a driver of the dynamic interaction between the real and the financial sectors. Such movement influences income determination in the real economy in the short period through aggregate demand leading to the emergence of two macroeconomic regimes. A short period flow model, underpinned by the stock flow consistent accounting framework, is developed to formalize the dynamics of interaction between real and financial sectors mediated by movement in asset price, generates bistability, abrupt crashes, and systemic fragility in the macroeconomic regimes.

2008

Abstract To provide a rigorous analysis of monetary policy in the face of financial instability, we extend the standard dynamic stochastic general equilibrium model to include a financial system. Our simulations suggest that if financial instability affects output and inflation with a lag, and if the central bank has privileged information about credit risk, monetary policy responding instantly to increased credit risk can trade off more output and inflation instability today for a faster return to the trend than a policy that follows the simple Taylor rule.