An expectations-driven interpretation of the “Great Recession”

• Published in: Journal of monetary economics Vol. 60; no. 4; pp. 391 - 407
• Main Authors: Gunn, Christopher M., Johri, Alok
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.05.2013; Elsevier Sequoia S.A
• Subjects: Asset pricing; Bankruptcy; Business cycles; Debt management; Economic theory; Financial services; Great Recession; Monetary economics; Rational expectations; Recession; Recessions; Stochastic models; Stochastic processes; Studies
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2013.04.003

The boom-years preceding the “great recession” were a time of rapid innovation in the financial industry. We explore the idea that both the boom and eventual bust emerged from overoptimistic expectations of efficiency-gains in the financial sector. We treat the bankruptcy costs facing intermediaries in a costly state verification problem as a stochastic process, and model the boom-bust in terms of an unfulfilled news-shock where the expected fall in costs are eventually not realized. In response to a change in expectations only, the model generates a boom-bust cycle in aggregate activity, asset prices and leverage, and a countercyclical credit spread. •We link the boom that preceded the "Great Recession" and the eventual bust together.•Expected gains from financial innovations may have been too optimistic.•We use a financial-accelerator framework in a real DGE model to study news-shocks.•Changes in expectations about future default costs generate a boom-bust cycle.•A boom in asset prices and leverage, accompany a countercyclical credit spread.