Time Varying Volatility and the Origins of Financial Crises
62 Pages Posted: 8 Oct 2014
Date Written: May 8, 2014
Abstract
I document that financial crises coincide with the sudden reversal of a long period of low aggregate volatility. I argue that shocks to the volatility of total factor productivity are a source of financial instability, and account for both the building-up of risk and the burst of financial crises. I develop a DSGE model with an occasionally binding collateral constraint and a frictional housing market which determines the liquidity of the collateral. In this environment, volatility shocks affect the frequency of fire sales by changing collateral liquidity. In a quantitative exercise, I find that the interaction of time-varying volatility and search frictions increases both the frequency financial crises and the corresponding fall in GDP by 62% and 71%, respectively. Moreover, in the model the liquidity of the collateral endogenizes agents' loan-to-value ratios. Volatility shocks generate sizable time variations in the loan-to-value ratios, providing a foundation of financial shocks.
Keywords: Collateral Liquidity, Housing Market, Non-Linear Dynamics, Occasionally Binding Borrowing Constraint, Search Frictions
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