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Time - Consistent Bailout Plans

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  • Ernesto Pastén

Abstract

Bailout policy is time-inconsistent, which results in multiple equilibria characterized by too much leverage, high risk correlation and little liquidity holding. I show that a long-run horizon allows the policy-maker to define bailout plans that rule out the worse equilibria. This result contrasts with the standard finding in environments with a unique equilibrium, as in most applications, in which a long-run horizon allows the policy-maker to support superior outcomes in equilibrium. I use this framework to discuss the effectiveness of three prudential policy proposals: too-big-to-fail size caps, taxes on borrowing and liquidity requirements. I also argue that policies alleviating the time-inconsistency of bailouts may generate large welfare gains. In this regard, I discuss three alternatives: policies against the scarcity of liquidity during crises, bailout design, and public debt.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 635.

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Date of creation: Jul 2011
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Handle: RePEc:chb:bcchwp:635

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  2. Acharya, Viral V & Yorulmazer, Tanju, 2004. "Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies," CEPR Discussion Papers 4778, C.E.P.R. Discussion Papers.
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  18. Dominguez, Begona, 2007. "Public debt and optimal taxes without commitment," Journal of Economic Theory, Elsevier, vol. 135(1), pages 159-170, July.
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Cited by:
  1. Farhi, Emmanuel & Tirole, Jean, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," IDEI Working Papers 571, Institut d'Économie Industrielle (IDEI), Toulouse, revised Oct 2010.

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