Abstract
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.
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