Crises are generally initiated by a moderate adverse shock that puts pressure on intermediaries’ balance sheets, triggering a creditor run, a contraction in new lending, and ultimately a deep and persistent recession.
Analysis of the term structure of interest rates almost always takes a two-step approach.
We find that the best predictor of future employment for the non-employed is their duration since last employment.
Interest rate rules with a positive weight on debt-to-GDP cause indeterminacy.
Compared to inflation targeting, debt-to-GDP stabilization calls for a more expansionary policy when debt-to-GDP is high, so as to deflate the debt burden through inflation and output growth.
This suggests that securitization in this market funds safe collateral.
How should a central bank act to stabilize the debt-to-GDP ratio?
We show how the persistent nature of household debt shapes the answer to this question.
In environments where households repay mortgages gradually, surprise interest hikes only weakly influence household debt, and tend to increase debt-to-GDP in the short run while reducing it in the medium run.
To illustrate the feasibility and desirability of the onestep approach, we compare arbitrage-free dynamic term structure models estimated using both approaches.
We also provide a simulation study showing that a one-step approach can extract the information in large panels of bond prices and avoid any arbitrary noise introduced from a first-stage interpolation of yields.
Overall, the results indicate that both the productive capacity of an economy and the distribution of income matter for financial stability.
Financial crises are born out of prolonged credit booms and depressed productivity.
Previous research showed that credit growth is a robust predictor of financial fragility.