Credit Cycles and the Role of Macro-prudential Policy
Friday, Jan. 5, 2018 2:30 PM - 4:30 PM
- Chair: Andrew Haldane, Bank of England
A Risk-centric Model of Demand Recessions and Macroprudential Policy
AbstractWhen investors are unwilling to hold the economy's risk, a decline in the interest rate increases the Sharpe ratio of the market and equilibrates the risk markets. If the interest rate is constrained from below, risk markets are instead equilibrated via a decline in asset prices. However, the latter drags down aggregate demand, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.
Credit, Risk Appetite, and Monetary Policy Transmission
AbstractWe show that the effects of financial conditions and monetary policy on U.S. economic performance depend nonlinearly on nonfinancial sector credit. When credit is below its trend, an impulse to financial conditions leads to improved economic performance and monetary policy transmission works as expected. By contrast, when credit is above trend, a similar impulse leads to an economic expansion in the near-term, but then a recession in later quarters. In addition, tighter monetary policy does not lead to tighter financial conditions when credit is above trend and is ineffective at slowing the economy, consistent with evidence of an attenuated transmission of policy changes to distant forward Treasury rates in high-credit periods. These results suggest that credit is an important conditioning variable for the effects of financial variables on macroeconomic performance.
Narratives, Social Contagion and Credit Booms
AbstractThis paper develops an analytical model of inefficient investment booms driven by a combination of informational and social contagion. An initial investment decision by a subset of agents reveals information, but also creates a positive narrative about an asset class that can transmit across a social network with arbitrary structure. Agents may collectively herd into the asset class because they are directly influenced by their peers when making decisions, a process we argue characterises phenomena such as housing bubbles. For a simple class of random networks, we explore analytically how the system's vulnerability to contagious cascades—situations in which a significantly larger proportion of agents decide to invest in the asset than is warranted by fundamentals—is influenced by the average connectivity of the network. We then simulate how the vulnerability of the system to cascades changes when we allow for a wider set of decision rules that feature informational contagion, and for richer, ‘fat-tailed’ social network structures that allow us to explore the role of key players in propagating social contagion of narratives. Finally, we assess how policy measures—including macroprudential policies that limit agents’ leverage and a ‘leaning against the wind’ monetary policy—could make the system less prone to such inefficient investment booms.
- E3 - Prices, Business Fluctuations, and Cycles
- G2 - Financial Institutions and Services