Open Yale CoursesECON 251: Financial TheoryLecture 26 - The Leverage Cycle and Crashes<< previous sessionOverview:In order to understand the precise predictions of the Leverage Cycle theory, in this last class we explicitlysolve two mathematical examples of leverage cycles. We show how supply and demand determine leverageas well as the interest rate, and how impatience and volatility play crucial roles in setting the interest rate andthe leverage. Mathematically, the model helps us identify the three key elements of a crisis. First, scary badnews increases uncertainty. Second, leverage collapses. Lastly, the most optimistic people get crushed, so thenew marginal buyers are far less sanguine about the economy. The result is that the drop in asset prices is
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