Modelling the global financial crisis

This paper models the global financial crisis as a combination of shocks to global housing markets and sharp increases in risk premia of firms, households, and international investors in an intertemporal (dynamic stochastic general equilibrium or DSGE) global model. The model has six sectors of production and trade in 15 major economies and regions. The paper shows that a 'switching' of expectations about risk premia shocks in financial markets can easily generate the severe economic contraction in global trade and production currently being experienced in 2009 and subsequent events. The results show that the future of the global economy depends critically on whether the shocks to risk are expected to be permanent or temporary. The best representation of the crisis may be onewhere initial long-lasting pessimism about risk is unexpectedly revised to a more moderate scenario. This suggests a rapid recovery in countries not experiencing a balance sheet adjustment problem.