We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. We confront the model with data on credit spreads, equity prices, credit, and output across the financial crisis cycle. In particular, we ask the model to match data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the post-crisis period characterized by a slow recovery in output.
The U.S. dollar exchange rate clears the global market for dollar-denominated safe assets. We find that shifts in the demand and supply of safe dollar assets are important drivers of variation in the dollar exchange rate, bond yields, and other global financial variables. An increase in the convenience yield that foreign investors derive from holding safe dollar assets causes the dollar to appreciate, and incentivizes foreign debtors to tilt their issuance towards dollar-denominated instruments. U.S.