Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium
AbstractIntroducing 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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Bibliographic InfoPaper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1316R2.
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
Note: CFP 1074.
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Find related papers by JEL classification:
- D4 - Microeconomics - - Market Structure and Pricing
- D5 - Microeconomics - - General Equilibrium and Disequilibrium
- D8 - Microeconomics - - Information, Knowledge, and Uncertainty
- D41 - Microeconomics - - Market Structure and Pricing - - - Perfect Competition
- D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
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- NEP-ALL-2003-10-28 (All new papers)
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