A Bad-Asset Theory of Financial Crises ∗ (Incomplete and preliminary)

We propose a simple model of financial crises, which may be useful for the unified analysis of macro and financial policies implemented during the 2008–2009 financial crisis. A financial crisis is modeled as a disappearance of inside money due to the lemon problem à la Akerlof (1970), in a simplistic variant of Lucas and Stokey’s (1987) Cash-in-Advance economy, where both cash and capital stocks work as media of exchange. The exogenous emergence of huge amount of bad assets represents the occurrence of a financial crisis. Information asymmetry regarding the good assets (capital stocks) and the bad assets causes the good assets to cease functioning as inside money. The private agents have no proper incentive to dispose of the bad assets and the crisis could be persistent, because the lemon problem is an external diseconomy. Macroeconomic policy (e.g., fiscal stimulus) provides outside money for substitution, and financial stabilization (e.g., bad-asset purchases) restores the inside money by resolving information asymmetry. The welfare-improving effect of the macro policy may be nonexistent or temporary, while the bad-asset purchases may have a permanent effect to shift the economy out of the crisis equilibrium. This paper is motivated by encouraging comments by Robert Lucas on the companion paper (“