Fire Sales and the Financial Accelerator

Author/Editor:

Woon Gyu Choi ; David Cook

Publication Date:

June 1, 2010

Electronic Access:

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Summary:

During periods of financial turmoil, increases in risk lead to higher default, foreclosure, and fire sales. This paper introduces a costly liquidation process for foreclosed collateral and endogenous recovery rates in a dynamic stochastic general equilibrium model of the financial accelerator. Consistent with empirical evidence, we find that recovery rates are pro-cyclical when collateral is costly to liquidate. Through links between recovery rates, risk premia, and default risk, the model generates an additional liquidity spiral, a feedback loop for the financial accelerator. We illustrate how collateral liquidation and monetary policy alter the impacts of a financial shock. We also show that a government subsidy on collateral liquidity and the endogenous accumulation of liquidity inventory help dampen the liquidity spiral by shoring up recovery rates.

Series:

Working Paper No. 10/141

Subject:

English

Publication Date:

June 1, 2010

ISBN/ISSN:

9781455201242/1018-5941

Stock No:

WPIEA2010141

Format:

Paper

Pages:

29

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