Modeling the Recent Financial Market Meltdown

It appears that many boom-bust cycles are driven by linkages between the credit
market and asset prices. Recently, in addition to credit, bonds and stocks, new complex
securities have been developed, e.g., MBS, CDO and CDS, that act as instruments of
financial intermediation and evaluation of credit risk. We study their role in the recent
financial market meltdown and how they exacerbate leverage cycles. We first introduce
a baseline model that allows for financial market boom-bust cycles. Then we extend
the model to demonstrate the magnifying efects arising from the pricing of the new
financial instruments. Finally, we summarize the mechanism of leverage cycles in a low
dimensional dynamic system. We also spell out some implication for monetary policy.
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