10 - Micro-foundations for Credit Creation and the Business Cycle

Summary

In this chapter, a self-organised criticality model of financial networks is developed mathematically and is applied computationally. It first establishes a complex network model of the equity identity of balance sheets. This is used to simulate various possible modes of operation of the financial system under different levels of stress and states of criticality, according to the distributions of the distance to insolvency of financial agents. This model can explain how the economy amplifies some small fluctuations into large scale financial crashes. It explains when and how the economy may be vulnerable to instability according to the topology of its financial network, and its distance to criticality according to the quantity of leverage that its financial agents have undertaken. Lastly, it identifies policy instruments effective at controlling the rate of growth of borrowing, systemic risk accumulation and collective risk-taking.