A Macroeconomic Model with a Financial Sector

A Macroeconomic Model with a Financial Sector

By
Markus K. Brunnermeier, Yuliy Sannikov
American Economic Review. February
2014, Vol. 104, Issue 2, Pages 379-421

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.