Boom-Bust Cycles: Leveraging, Complex Securities, and Asset Prices

Abstract

It appears that many boom-bust cycles are driven by linkages between the credit market and asset prices. Recently, in addition to credit, bonds and stocks, new complex securities have been developed, e.g., MBS, CDO and CDS, that act as instruments of financial intermediation and evaluation of credit risk. We study their role in the recent financial market meltdown and how they exacerbate leverage cycles. We first introduce a baseline model that allows for financial market boom-bust cycles. Then we extend the model to demonstrate the magnifying effects arising from the pricing of the new financial instruments. Finally, we summarize the mechanism of leverage cycles in a low dimensional dynamic system. We also spell out some implication for monetary policy.