Fire Sales and the Financial Accelerator

June 1, 2010

Preview Citation

Format: Chicago

Woon Gyu Choi, and David Cook. Fire Sales and the Financial Accelerator, (USA: International Monetary Fund, 2010) accessed October 6, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

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.

Subject: Collateral, Financial crises, Liquidity, Return on investment, Self-employment

Keywords: Panel E, WP

Publication Details

Pages:

29
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2010/141
Stock No:

WPIEA2010141
ISBN:

9781455201242
ISSN:

1018-5941

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