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Promises Promises

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    Abstract

    In the classical general equilibrium model, agents keep all their promises, every good is traded, and competition prevents any agent from earning superior returns on investments in financial markets. In this paper I introduce the age-old problem of broken promises into the general equilibrium model, and I find that a new market dynamic emerges. Given the legal system and institutions, market forces of supply and demand will establish the collateral levels which are required to secure promises. Since physical collateral will typically be scarce, these collateral levels will be set so low that there is bound to be some default. Many kinds of promises will not be traded, because that also economizes on collateral. Scarce collateral thus creates a mechanism for determining endogenously which assets will be traded, thereby helping to resolve a long standing puzzle in general equilibrium theory. Finally, I shall show that under suitable conditions, in rational expectations equilibrium, some investors will be able to earn higher than normal returns on their investments. The legal system, in conjunction with the market, will be under constant pressure to expand the potential sources of collateral. This will lead to market innovation. I illustrate the theoretical points in this paper with some of my experiences on Wall Street as director of fixed income research at the firm of Kidder Peabody.

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    File URL: http://cowles.econ.yale.edu/P/cd/d11a/d1143.pdf
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    Bibliographic Info

    Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1143.

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    Length: 32 pages
    Date of creation: Dec 1996
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    Publication status: Published in W.B. Arthur, S.N. Durlauf and D.A. Lane, eds., The Economy as an Evolving Complex System II, Addison-Wesley, 1997, pp. 285-320
    Handle: RePEc:cwl:cwldpp:1143

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    Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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    1. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
    2. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
    3. William R. Zame, 1992. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 673, UCLA Department of Economics.
    4. Smith, Vernon L, 1972. "Default Risk, Scale, and the Homemade Leverage Theorem," American Economic Review, American Economic Association, vol. 62(1), pages 66-76, March.
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    Cited by:
    1. Orrillo, Jaime, 2005. "Collateral once again," Economics Letters, Elsevier, vol. 87(1), pages 27-33, April.
    2. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 1-37, 01.
    3. Jaime Jose Orrillo Carhuajulca, 2000. "Default and Exogenous Collateral in Incomplete Markets with a Continuum of States," Econometric Society World Congress 2000 Contributed Papers 1860, Econometric Society.
    4. Steinert, Mariano & Torres-Martinez, Juan Pablo, 2007. "General equilibrium in CLO markets," Journal of Mathematical Economics, Elsevier, vol. 43(6), pages 709-734, August.
    5. Eduardo Siandra, 2002. "The Economics of financial Matching," Documentos de Trabajo (working papers) 1002, Department of Economics - dECON.

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