Financial crises often involve amplification effects whereby adverse developments in financial markets and in the real economy mutually reinforce each other. The literature in macroeconomics has typically emphasized the following four elements to describe financial amplification effects: 1 First, individual agents face financial constraints that limit their economic activity, e.g. by constraining the amount of funds available for investment. Second, the aggregate level of economic activity affects the price of productive assets in the sector. Third, the price of productive assets determines the net worth of individual agents who own them. Fourth, net worth governs the tightness of their financial constraints by affecting the availability or price of external finance. This reduces economic activity further, which in turn depresses asset prices further and so on, leading to a self-reinforcing cycle of falling asset prices, deteriorating net worth, tightening financing conditions, and declining economic activity.
A shock to any of the four elements involved – financing capacity, economic activity, asset prices, or net worth – can trigger amplification effects when financing constraints are binding. For example, a negative shock to the net worth of financial institutions can trigger sharp declines in their financing capacity, their lending activity, the financial health of their borrowers and hence the value of their loan portfolio, and their net worth. 2 Financial crises entail large welfare costs and are therefore of great concern to both economists and policymakers. Every financial crisis – including the current subprime crisis – therefore brings up the question of whether exisiting regulations are sufficient or new regulations to limit risk-taking by financial market participants are desirable.
For government regulations to enhance social welfare, they must correct a market imperfection. In other words, if markets functioned well and rational market participants knowingly took on extensive risk, then crises would be a socially efficient outcome (see e.g. Allen and Gale, 1998), and government regulations to limit risk-taking would reduce social welfare.
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Systemic Risk-Taking: Accelerator Effects, Externalities, and Regulatory Responses
