Marzio Bassanin, Ester Faia, Valeria Patella, 30 August 2019

Macroeconomic models with credit frictions do a good job of explaining debt falls during financial crises, but fail to account for pre-crisis debt increases and level pro-cyclicality. This column introduces a model in which investors’ beliefs about future collateral values are non-linear. Greater ambiguity optimism during booms and greater aversion during recessions closely model the empirical shifts seen before and during financial crises, highlighting the joint role of financial frictions and beliefs distortions for market developments.

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