We develop a model of financial crises with both a financial amplification mecha-
nism, via frictional intermediation, and a role for sentiment, via time-varying beliefs
about an illiquidity state. We confront the model with data on credit spreads, equity
prices, credit, and output across the financial crisis cycle. In particular, we ask the
model to match data on the frothy pre-crisis behavior of asset markets and credit,
the sharp transition to a crisis where asset values fall, disintermediation occurs and
output falls, and the post-crisis period characterized by a slow recovery in output.
Our model with the frictional intermediation mechanism and fluctuations in beliefs
provides a parsimonious account of the entire crisis cycle. The model with only the
frictional intermediation mechanism misses the frothy pre-crisis behavior; fluctuations
in beliefs resolve this problem. On the other hand, modeling the belief variation via
either a Bayesian or diagnostic model match the broad patterns, with each missing
some targets to different extents. We also show that a lean-against-the-wind policy
has a quantitatively similar impact in both versions of the belief model, indicating
that policy need not “get into the minds” of investors and condition on the true belief
For more information please visit the Stern Macroeconomics website.
If you would like to be added to the distribution list or for further details regarding this seminar, please contact Erica Loh at firstname.lastname@example.org.