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A continuous-time macro-finance model with Knightian uncertainty

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  • Mao, Jie
  • Shen, Guanxiong
  • Yan, Jingzhou

Abstract

This study presents a continuous-time macro-finance model with Knightian uncertainty to solve the full equilibrium dynamics of the economy and examine the impacts of Knightian uncertainty on systemic risk, which we find to be asymmetric and dependent on the state of the economy. We summarize this phenomenon as the Knightian uncertainty paradox: uncertainty increases systemic risk by reducing market liquidity in the normal regime, but mitigates it by lowering leverage in the crisis regime. Thereafter, we confirm the existence of this paradox using data from China. Additionally, the impacts of macro-prudential policies are evaluated. We confirm that these policies effectively mitigate systemic risk and postpone the Minsky moment; however, they are detrimental to social welfare and retard economic recovery.

Suggested Citation

  • Mao, Jie & Shen, Guanxiong & Yan, Jingzhou, 2023. "A continuous-time macro-finance model with Knightian uncertainty," Pacific-Basin Finance Journal, Elsevier, vol. 77(C).
    • Handle: RePEc:eee:pacfin:v:77:y:2023:i:c:s0927538x22002244
    DOI: 10.1016/j.pacfin.2022.101929
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    Keywords

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    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E69 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Other
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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