Predicting and Preventing Financial Crashes: Leaning Against the Bubbly Wind
Fluctuations in asset prices during financial crises are caused by credit-driven bubbles in the banking sector. These bubbles reach unsustainable levels due to agency problems. The peak and collapse of a bubble can be predicted based on certain parameters. Tightening monetary policy can reduce the size of a bubble, while stricter regulations may worsen it. The theory suggests that it's better to counteract the bubble rather than restricting borrowers to stabilize the economy.