infonet-economy

We offer a rational expectations model of the dynamics of innovative industries. The fundamentalvalue of innovations is uncertain and one must learn whether they are solid or fragile. Also, when theindustry is new, it is difficult to monitor managers and make sure they exert the effort necessary toreduce default risk. This gives rise to moral hazard. In this context, initial successes spur optimismand growth. But increasingly confident managers end up requesting large rents. If these becometoo high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise toendogenous crises and fat tails in the distribution of aggregate default risk. We calibrate our modelto fit the stylized facts of the MBS industry’s boom and bust cycle.2