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Contagious Adverse Selection

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  • Stephen Morris
  • Hyun Song Shin

Abstract

We illustrate the corrosive effect of even small amounts of adverse selection in an asset market and show how it can lead to the total breakdown of trade. The problem is the failure of "market confidence," defined as approximate common knowledge of an upper bound on expected losses. Small probability events can unravel market confidence. We discuss the role of contagious adverse selection and the problem of "toxic assets" in the recent financial crisis. (JEL D82, G01, G12, G14)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/mac.4.1.1
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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 4 (2012)
Issue (Month): 1 (January)
Pages: 1-21

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Handle: RePEc:aea:aejmac:v:4:y:2012:i:1:p:1-21

Note: DOI: 10.1257/mac.4.1.1
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  1. Reny, P.J. & Bhattacharya, U. & Spiegel, M., 1993. "Destructive Interference in an Imperfectly Competitive Multi-Security Market," UWO Department of Economics Working Papers 9318, University of Western Ontario, Department of Economics.
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Cited by:
  1. Timothy Shields & Baohua Xin, 2012. "Higher-order Beliefs in Simple Trading Models," Working Papers 12-18, Chapman University, Economic Science Institute.
  2. Grzegorz Hałaj & Christoffer Kok, 2013. "Assessing interbank contagion using simulated networks," Computational Management Science, Springer, vol. 10(2), pages 157-186, June.
  3. Agur, Itai, 2013. "Multiple bank regulators and risk taking," Journal of Financial Stability, Elsevier, vol. 9(3), pages 259-268.
  4. Prokopczuk, Marcel & Siewert, Jan B. & Vonhoff, Volker, 2013. "Credit risk in covered bonds," Journal of Empirical Finance, Elsevier, vol. 21(C), pages 102-120.
  5. Itay Goldstein & Assaf Razin, 2013. "Three Branches of Theories of Financial Crises," NBER Working Papers 18670, National Bureau of Economic Research, Inc.
  6. Diego Moreno & John Wooders, 2013. "Dynamic Markets for Lemons: Performance, Liquidity, and Policy Intervention," Working Paper Series 5, Economics Discipline Group, UTS Business School, University of Technology, Sydney.

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