This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes- a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other by not maintaining adequate capital cushion.

I survey the major results in the theory of general equilibrium with incomplete asset markets. I also

In the wake of the 2008 international financial crisis, there have been intense debates about reform of the international financial system that emphasize the need to address the problem of "overborrowing." The argument typically relies on the observation that periods of sustained increases in borrowing are often followed by a devastating disruption in financial markets. This raises the question of why the private sector becomes exposed to the dire consequences of financial crises and what the appropriate policy response should be to reduce the vulnerability to these episodes. Without a thorough understanding of the underlying inefficiencies that arise in the financial sector, it seems difficult to evaluate the merit of proposals that aim to reform the current international financial architecture. This paper presents a formal welfare-based analysis of how optimal borrowing decisions at the individual level can lead to overborrowing at the social level in a dynamic stochastic general equilibrium (DSGE) model, where financial constraints give rise to amplification effects. As in the theoretical literature (e.g. Guido Lorenzoni 2008), we analyze constrained efficiency by considering a social planner that faces the same financial constraints as the private economy, but internalizes the price effects of its borrowing decisions. Unlike the existing literature, we conduct a quantitative analysis to evaluate the macroeconomic and welfare effects of overborrowing. We study how overborrowing affects the incidence and

We examine the impact of community interaction on risk sharing, investments and consumption. We do this using a rational general equilibrium model in which agents care only about their personal consumption. We consider a setting in which, due to borrowing constraints, individuals who are endowed with local resources under-participate in financial markets. As a result, individuals “compete ” for local resources through their portfolio choices. Even with complete financial markets (in the sense of spanning) and no aggregate risk, in stable equilibria agents herd into risky portfolios. This yields a Pareto dominated outcome as agents introduce “community ” risk that does not follow from fundamentals. This framework allows us to examine the influence of behavioral agents on the equilibrium portfolio choices of other agents in the community. We show that when some agents are behaviorally biased, equilibria exist in which rational agents choose even more extreme portfolios and amplify the behavioral effect. This can rationalize the behavioral bias, as following the behavioral bias is optimal. A similar effect will result if some investors cannot completely diversify their holdings (for control or moral hazard reasons) and are biased towards a certain sector. Finally, we show that in our model, equilibrium Sharpe ratios can be high, even absent aggregate consumption risk. We also show that from a welfare perspective diversification has “public good ” features. This provides a potential justification for policies that subsidize diversified holdings and limit trade in risky securities.

This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to nonlinear amplification effects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate downturns. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained efficient and the issuance of government debt can lead to a Pareto improvement. While financial institutions can mitigate frictions, they introduce additional fragility and through their erratic money creation harm price stability.

We present a rational general equilibrium model that highlights the fact that relative wealth concerns can play a role in explaining financial bubbles. We consider a finite-horizon overlapping generations model in which agents care only about their consumption. Though the horizon is finite, competition over future investment opportunities makes agents' utilities dependent on the wealth of their cohort and induces relative wealth concerns. Agents herd into risky securities and drive down their expected return. Even though the bubble is likely to burst and lead to a substantial loss, agents' relative wealth concerns make them afraid to trade against the crowd. (JEL G11, G12, D52, D53, D91, E43) In this article we present a stylized model that highlights the fact that relative wealth concerns may play an important role in explaining the presence and dynamics of financial ''bubbles'' and excess volatility. The role of relative wealth concerns in explaining these phenomena is quite simple. In standard models, rational agents exploit price anomalies by selling overpriced assets and buying undervalued assets. This activity of ''buy low/sell high'' eliminates price distortions in equilibrium. However, if agents are sensitive to the wealth of others, trading against the crowd increases the risk of their relative wealth. As a result, rational traders may sustain prices that are too high even though they understand that these prices deviate substantially from fundamentals. Thus, relative wealth concerns help support the existence of financial bubbles by increasing the risk of trading against the crowd. We show in We have benefited from comments by Maureen O'Hara (the editor), Chester Spatt, Johan Walden, Wei Xiong, and an anonymous referee as well as seminar participants at Brigham

Abstract We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the "risk-taking channel" of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.

This paper provides an introduction to the new economics of prudential capital controls in emerging economies. This literature is based on the notion that there are externalities associated with financial crises because individual market participants do not internalize their contribution to aggregate financial instability. We describe financial crises as situations in which an emerging economy loses access to interna-tional financial markets and experiences a feedback loop in which declining aggre-gate demand, falling exchange rates and asset prices, and deteriorating balance sheets mutually reinforce each other—a common phenomenon in recent emerging market crises. Individual market participants take aggregate prices and financial conditions as given and do not internalize their contribution to financial instability when they choose their actions. As a result they impose externalities in the form of greater financial instability on each other, and the private financing decisions of individuals are distorted toward excessive risk-taking. Prudential capital controls can induce private agents to internalize their externalities and thereby increase macroeconomic stability and enhance welfare. [JEL F34, F41, E44, H23]

We present a model of financial market liquidity provided by financially constrained intermediaries. We show that market liquidity increases with the level of intermediary capital. We also characterize conditions under which intermediaries play a stabilizing or destabilizing role in markets. Finally, we sketch a number of areas, including welfare and public policy, on which the model can shed light.

This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future