Risk Allocation, Debt Fueled Expansion and Financial Crisis.” NBER Working Paper No

In this paper we discuss how several macroeconomic features of the 2001-2008 pe-riod may have resulted from a process in which financial markets were trying to allo-cate risk between heterogeneous agents when productive investment opportunities are scarce. We begin by showing how heterogeneity in terms of risk tolerance can cause financial markets to propagate transitory shocks and induce higher output volatility, albeit with a higher mean. We then show how this simple heterogeneous agent frame-work can explain an expansion driven by the growth in consumer debt, and why the equilibrium path of such an economy is likely fragile. In particular, we demonstrate that the emergence of a small amount of asymmetric information can make the econ-omy susceptible to changes in expectations that can induce large reversals of financial flows, the freezing of assets and a recession that can persist despite high productivity