Financial destabilization

Abstract

This paper uses a dynamic general equilibrium model to examine whether financial innovations destabilize an economy in which a representative firm operates one production sector with a neoclassical production function. Entrepreneurs receive individual-specific productivity shocks in each period. Entrepreneurs who draw higher productivity shocks become capital producers and borrow production resources in the financial market, whereas entrepreneurs who draw lower productivity shocks become lenders. Capital producers face financial frictions and can borrow only up to a certain proportion of their funds. Under an empirically plausible elasticity of substitution between capital and labor, as financial frictions are mitigated, the economy loses stability, and a flip bifurcation occurs at a certain level of financial frictions. In some cases, a cycle with more than two periods and complex dynamics arise as period-doubling bifurcations repeatedly occur. In any case, the amplitude of fluctuations increases as financial frictions faced by capital producers are mitigated and is maximized when they are eliminated. These outcomes imply that financial innovations are likely to destabilize an economy.