Financial Innovation, Macroeconomic Stability and Systemic Crises

41 Pages Posted: 31 Mar 2008

See all articles by Prasanna Gai

Prasanna Gai

University of Auckland Business School; Australian National University (ANU); Bank of England

Sujit Kapadia

Bank of England; European Central Bank (ECB)

Stephen Millard

Bank of England

Ander Perez-Orive

Board of Governors of the Federal Reserve System

Date Written: February 2008

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 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.

Keywords: Systemic financial crises, financial innovation, macroeconomic stability, modern financial systems, fire sales

JEL Classification: E32, E44, G13, G2

Suggested Citation

Gai, Prasanna and Kapadia, Sujit and Kapadia, Sujit and Millard, Stephen and Perez-Orive, Ander, Financial Innovation, Macroeconomic Stability and Systemic Crises (February 2008). Bank of England Working Paper No. 340, Available at SSRN: https://ssrn.com/abstract=1114071 or http://dx.doi.org/10.2139/ssrn.1114071

Prasanna Gai

University of Auckland Business School ( email )

12 Grafton Rd
Private Bag 92019
Auckland, 1010
New Zealand

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom
+020 7601 3583 (Phone)

Sujit Kapadia (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom
020-7601-5507 (Phone)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Stephen Millard

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Ander Perez-Orive

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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