##gressive dynamics. but with reputational externalities, productivity shocks become amplified by the credit cycle : a high realisation of in period could push the macro state above the risky policy threshold, at which point the dynamics of begin also to shape the real economy. the distribution of is assumed to have a higher mean and variance than to simulate the effects of the credit boom. in particular, we constrain the distribution of relative to such that expected risk - adjusted fundamentals are constant over time. 10 so we have, in effect, a regime - switching model. when banks play safe strategies, fundamentals are relatively stable. when banks risk up, they create a temporary improvement in expected fundamentals at the cost of greater volatility. this dynamic specification has some interesting properties. first, even small shocks can have disproportionately large effects on fundamentals depending on the initial conditions. in particular, if fundamentals happen to be close to the switching threshold, a further positive shock will lead all firms to coordinate on the high risk - taking strategy. that drives up both the expected value of fundamentals and its volatility. this generates a form of path dependence. second, credit cycles are endogenous in this framework. as firms coordinate on high risk strategies, this drives up the expected value of fundamentals. but it also drives up volatility due to risk illusion. because riskadjusted returns are constant, this must entail an increase in the probability of there being a severe negative shock, so the probability of a crash rises. chart 2 shows a simulation of the model when for 100 periods with normally distributed shocks. the frictionless benchmark model generates the path shown by the maroon line. as specified, the path is mean reverting, with movements in the macro state around trend. allowing for reputational effects generates the blue path, giving a threshold level of fundamentals shown by the green dashed line. as the macro state hits the threshold, banks adopt risky policies to signal high ability. in this simulation this happens four times, in periods 3, 50, 68 and 72. consider the threshold breach in period 72. as during the great moderation, the good macro state at first persists. the credit boom fuels high fundamentals. but while headline fundamentals have improved, risk - adjusted fundamentals have not. eventually, this results in a crunch in credit and a sharp deterioration in the macro state, as risk is realised. in particular,

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