NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

A Model of Capital and Crises

Zhiguo He, Arvind Krishnamurthy

NBER Working Paper No. 14366
Issued in September 2008
NBER Program(s):   AP   CF

We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates.

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This paper was revised on December 5, 2011

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Document Object Identifier (DOI): 10.3386/w14366

Published: A Model of Capital and Crises, 2012, with Arvind Krishnamurthy, Review of Economic Studies 79(2): pp. 735-777. Presentation Slides.

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