Time - Consistent Bailout Plans
AbstractBailout 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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Bibliographic InfoPaper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 635.
Date of creation: Jul 2011
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-09-05 (All new papers)
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