A Macroeconomic Model with a Financial Sector

TLDR

The economy is prone to instability and volatile crises due to highly nonlinear amplification effects. The study analyzes the full equilibrium dynamics of an economy with financial frictions. Endogenous risk driven by asset illiquidity persists in crisis even at low exogenous risk, a phenomenon termed the volatility paradox that resolves the Kocherlakota critique; endogenous leverage determines distance to crisis, and securitization and derivatives that improve risk sharing can raise leverage and increase crisis frequency. JEL codes: E13, E32, E44, E52, G01, G12, G20.

Abstract

This article studies the full equilibrium dynamics of an economy with financial frictions. Due to highly nonlinear amplification effects, the economy is prone to instability and occasionally enters volatile crisis episodes. Endogenous risk, driven by asset illiquidity, persists in crisis even for very low levels of exogenous risk. This phenomenon, which we call the volatility paradox, resolves the Kocherlakota ( 2000) critique. Endogenous leverage determines the distance to crisis. Securitization and derivatives contracts that improve risk sharing may lead to higher leverage and more frequent crises. (JEL E13, E32, E44, E52, G01, G12, G20)