Macroeconomic Model with Heterogenous Agents and Financial Frictions: A Continuous Time Diffusion Model Approach

This paper studies a simple stylized set up and numerical solution for an economy with heterogeneous agents with financial frictions. Equilibrium dynamics are characterized by a relatively stable steady state and a crisis regime. Due to nonlinear amplification effects, the economy is vulnerable to instability and may enter the crisis regime. Once in the crisis regime, endogenous risk, driven by asset illiquidity stress can persists for a long period, even for very low levels of fundamental exogenous shocks, a phenomenon known as volatility paradox. Endogenous leverage provides the depth of the financial crisis