The Financial Origins of Non-fundamental Risk

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We explore the idea that the financial sector can be a source of non-fundamental risk to the rest of the economy. We also consider whether policy can be used to reduce this risk.

Fearing that asset prices might fall, investors could demand safe assets from financial intermediaries. When leveraged intermediaries issue safe assets, this in turn exposes the economy to self-fulfilling asset price crashes.

We show that fiscal and monetary policy can prevent such price volatility in either of two ways:

  • The fiscal authority can issue debt or bail out intermediaries, thereby increasing the supply of publicly backed safe assets.
  • The fiscal authority can provide social insurance or central banks can commit to act as a market maker of last resort, thereby reducing the demand for safe assets.