Overborrowing, Financial Crises and ‘Macro-Prudential’ Policy?

54 Pages Posted: 7 Feb 2011

See all articles by Javier Bianchi

Javier Bianchi

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Date Written: February 2011

Abstract

This paper studies overborrowing, financial crises and macro-prudential policy in an equilibrium model of business cycles and asset prices with collateral constraints. Agents in a decentralized competitive equilibrium do not internalize the negative effects of asset fire-sales on the value of other agents' assets and hence "they borrow too much" ex ante, compared with a constrained social planner who internalizes these effects. Average debt and leverage ratios are slightly larger in the competitive equilibrium, but the incidence and magnitude of financial crises are much larger. Excess asset returns, Sharpe ratios and the market price of risk are also much larger. State-contigent taxes on debt and dividends of about 1 and -0.5 percent on average respectively support the planner’s allocations as a competitive equilibrium and increase social welfare.

Keywords: Borrowing, Business cycles, Credit, Economic models, Financial crisis, Global Financial Crisis 2008-2009

Suggested Citation

Bianchi, Javier and Mendoza, Enrique G., Overborrowing, Financial Crises and ‘Macro-Prudential’ Policy? (February 2011). IMF Working Paper No. 11/24, Available at SSRN: https://ssrn.com/abstract=1755441

Javier Bianchi

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Enrique G. Mendoza

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

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