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A Model Of Financial Crises: Coordination Failure Due To Bad Assets

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Executive Summary

This paper constructs a model of financial crises that can explain characteristic features of the global financial crisis of 2008-2009, namely, the widespread freezing of asset transactions, the sharp contraction of aggregate output, and deterioration in the labor wedge. This paper assumes that banks sell corporate bonds in the interbank market to raise money for short-term loans. The emergence of bad assets subsequent to the collapse of the asset-price bubble and asymmetric information among banks causes a freezing in the asset trading among banks (the market for lemons). Market freezing constrains the availability of bank loans as working capital for productive firms, causing output and the labor wedge to deteriorate.

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