A model of financial fragility
AbstractThis paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects’ operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crises can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.
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Bibliographic InfoPaper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number 98-01.
Date of creation: 1998
Date of revision:
Other versions of this item:
- C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G20 - Financial Economics - - Financial Institutions and Services - - - General
This paper has been announced in the following NEP Reports:
- NEP-ALL-1998-10-15 (All new papers)
- NEP-FMK-1998-10-15 (Financial Markets)
- NEP-IFN-1998-10-15 (International Finance)
- NEP-PKE-1998-10-15 (Post Keynesian Economics)
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