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Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium

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    Abstract

    Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented. When new information raises the probability a fixed income asset may default, its drop in price may be much greater than its objective drop in value because the drop in value reduces the relative wealth of its natural buyers, who disproportiantely own the asset through leveraged purchases. When the information also shortens the horizon over which the asset might default, its price falls still further because the margin requirement for its purchase endogenously rises. There may be spillovers in which other assets also crash in price even though their probability of default did not change.

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    File URL: http://cowles.econ.yale.edu/P/cd/d13a/d1316-r2.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 1316R2.

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    Length: 35 pages
    Date of creation: Aug 2001
    Date of revision: Jun 2002
    Publication status: Published in M. Dewabtripont, L.P. Hansen, and S.J. Turnovsky, eds., Advances in Economics and Econometrics II, Cambridge University Press, 2003, pp. 170-205
    Handle: RePEc:cwl:cwldpp:1316r2

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    Related research

    Keywords: Liquidity; default; collateral; crashes; general equilibrium; contracts; spillover; liquidity premium;

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    Cited by:
    1. Edelberg, Wendy, 2006. "Risk-based pricing of interest rates for consumer loans," Journal of Monetary Economics, Elsevier, vol. 53(8), pages 2283-2298, November.
    2. Silvia Magri & Raffaella Pico, 2010. "The rise of risk-based pricing of mortgage interest rates in Italy," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 778, Bank of Italy, Economic Research and International Relations Area.
    3. Filippo Taddei, 2007. "Equity Premium: Interaction of Belief Heterogeneity and Distribution of Wealth?," Carlo Alberto Notebooks 67, Collegio Carlo Alberto.

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