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Financial instability, political crises and contagion

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  • V. Vaugirard

Abstract

This paper studies banking liquidity crises under the assumption that the government may have private benefits in bailing-out a collapsing banking sector for reputation concerns. This political distortion feeds political uncertainty, as citizens may not agree with a bailout decision and overthrow the government. This paper shows that higher political uncertainty increases both financial and political instabilities as it enlarges the set of parameters for which bank runs and the dismissal of the government are optimal. Higher political uncertainty may stem from the occurrence of a politico-financial crisis in another similar country. Contagion takes place if citizens update their beliefs on the type of their government. Doing so, they may reinforce their beliefs that the government is self-interested and bank bailouts are not socially optimal. JEL Classification: F3, G2, D8.

Suggested Citation

  • V. Vaugirard, 2007. "Financial instability, political crises and contagion," Recherches économiques de Louvain, De Boeck Université, vol. 73(4), pages 347-367.
  • Handle: RePEc:cai:reldbu:rel_734_0347
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    More about this item

    Keywords

    banking liquidity crisis; bailout; political crisis; contagion;

    JEL classification:

    • F3 - International Economics - - International Finance
    • G2 - Financial Economics - - Financial Institutions and Services
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty

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