This paper proposes a tractable model of the Global Financial Cycle and studies its welfare implications for emerging market economies (EMEs). When local firms issue debt denominated in dollars, central banks must increase their policy rate as the U.S. tightens in order to offset balance sheet effects stemming from the depreciation of their currency. If global financial markets are imperfect, a novel externality emerges through the balance sheet of global intermediaries: a greater quantity of capital flows must be intermediated, which leads to a higher premium on the dollar interest rate, exacerbating the Global Financial Cycle. This bottleneck externality requires further tightening and results in inefficiently low levels of output and employment in EMEs. On the contrary, discouraging debt issuance in dollars through macroprudential policy has positive spillovers. Its optimal use dampens the Global Financial Cycle and its inefficiencies.

This paper proposes a theory of large-scale government bond purchases by central banks in an environment with endogenous information acquisition. Information production has two competing effects: it lowers risk premia by reducing uncertainty, but makes prices more sensitive to news. Central bank purchases crowd out private information acquisition by shifting risk off private balance sheets. When the sovereign can face self-fulfilling roll-over crises, however, this can be beneficial: impairing price informativeness prevents bond prices from falling below crisis-triggering thresholds. A key property of the model is that substantial purchases may be required to eliminate equilibrium multiplicity. Anticipation of such programs leads to excessive indebtedness, forcing the central bank to maintain an inflated balance sheet with prices disconnected from fundamentals. Evidence from Italian bonds around the ECB's 2015 program shows several informativeness measures fall after purchases begin and rise when purchases are reduced.

We develop a dynamic theory of “Partial Equilibrium Thinking” (PET), which micro-founds time-varying return extrapolation: extrapolative beliefs are present at all times, but only sometimes manifest themselves in explosive ways. We formalize the distinction between normal times shocks and “displacement shocks” (Kindleberger 1978), and study their interaction with extrapolative beliefs. In normal times, PET generates constant extrapolation and momentum. Following a displacement shock that increases uncertainty, PET leads to stronger and time-varying extrapolation, triggering bubbles and endogenous crashes. Our theory sheds light on both normal times market dynamics and Kindleberger’s narrative of bubbles within a unified framework.

Should policymakers adapt their macroprudential and monetary policies when the financial sector is vulnerable to belief-driven boom-bust cycles? I develop a model in which financial intermediaries are subject to collateral constraints, and that features a general class of deviations from rational expectations. I show that distinguishing between the drivers of behavioral biases matters for the precise calibration of policy: when biases are a function of equilibrium asset prices, as in return extrapolation, new externalities arise, even in models that do not have any room for policy in their rational benchmark. These effects are robust to the degree of sophistication of agents regarding their future biases. I show how time-varying leverage, investment and price regulations can achieve constrained efficiency. Importantly, greater uncertainty about the extent of behavioral biases in financial markets reinforces incentives for preventive action.

We study mislearning from equilibrium prices, and contrast this with mislearning from exogenous fundamentals. We micro-found mislearning from prices with a psychologically founded theory of "Partial Equilibrium Thinking" (PET), where traders learn fundamental information from prices, but fail to realize others do so too. PET leads to over-reaction, and upward sloping demand curves, thus contributing to more inelastic markets. The degree of individual-level over-reaction, and the extent of inelasticity varies with the composition of traders, and with the informativeness of new information. More generally, unlike mislearning from fundamentals, mislearning from prices i) generates a two-way feedback between prices and beliefs that can provide an arbitrarily large amount of amplification, and ii) can rationalize both over-reaction and more inelastic markets. The two classes of biases are not mutually exclusive. Instead, they interact in very natural ways, and mislearning from prices can vastly amplify mislearning from fundamentals.