Pricing systemic crises: monetary and fiscal policy when savers are uncertain
AbstractThe return on assets depends on the joint behavior of all savers; if all sell the asset simultaneously, then there will be a financial "Armageddon." We assume that risk-neutral savers' information about aggregate investment is too vague to form precise probability estimates, so they have Knightian uncertainty, and thus act to maximize their minimum payoff. Savers invest in a risky asset (economy-wide production) and in a riskless asset (government bonds). In times of high uncertainty, savers hold too many government bonds, lowering output. A monetary policy of lowering the risk-free rate causes savers to save less in total but to invest more in the risky asset, and the policy is shown to be Pareto-improving; but the policy is unable to recapture the optimal allocations. To restore investment and total savings to their optimal levels, the government must also use a fiscal policy of distortionary taxes to discourage current consumption and leisure.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-33.
Date of creation: 1999
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-1999-10-20 (All new papers)
- NEP-MON-1999-10-20 (Monetary Economics)
- NEP-PUB-1999-10-20 (Public Finance)
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