Abstract:
[Introduction] Boom-bust cycles in asset prices and economic activity are a central issue in policy and academic debates. An increasing rate of default on mortgage loans in the U.S. precipitated the financial crisis of 2007. A large stock of debt and high asset prices have been both a cause and a consequence of the crisis because more borrowers had access to bigger loans at lower rates of interest. The prolonged recession and difficult recovery highlight the fact that financial frictions are a key driver of business cycle fluctuations. During normal times imbalances emerge and the financial sector can mitigate financial frictions. Yet, during periods of crisis wealth can be destroyed and the financial sector adds fragility and instability to the whole economy. [...]
