Financial Innovation, Macroeconomic Stability and Systemic Crises

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We present a general equilibrium model of intermediation designed to capture some of the key features of the modernnancial system. The model incorporatesnan- cial constraints and state-contingent contracts, and contains a clearly dened pe- cuniary externality associated with assetre sales during periods of stress. If a sufciently severe shock occurs during a credit expansion, this externality is capa- ble of generating a systemicnancial crisis that may be self-fullling. Our model suggests thatnancial innovation and greater macroeconomic stability may have madenancial crises in developed countries less likely than in the past, but poten- tially more severe.