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Time - Consistent Bailout Plans

  • Ernesto Pastén

Bailout policy is time-inconsistent, which results in multiple equilibria characterized by too much leverage, high risk correlation and little liquidity holding. I show that a long-run horizon allows the policy-maker to define bailout plans that rule out the worse equilibria. This result contrasts with the standard finding in environments with a unique equilibrium, as in most applications, in which a long-run horizon allows the policy-maker to support superior outcomes in equilibrium. I use this framework to discuss the effectiveness of three prudential policy proposals: too-big-to-fail size caps, taxes on borrowing and liquidity requirements. I also argue that policies alleviating the time-inconsistency of bailouts may generate large welfare gains. In this regard, I discuss three alternatives: policies against the scarcity of liquidity during crises, bailout design, and public debt.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 635.

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Date of creation: Jul 2011
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Handle: RePEc:chb:bcchwp:635
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  1. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  2. Dominguez, Begona, 2007. "Public debt and optimal taxes without commitment," Journal of Economic Theory, Elsevier, vol. 135(1), pages 159-170, July.
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  7. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 16270, University Library of Munich, Germany.
  8. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  9. Huberto M. Ennis & Todd Keister, 2009. "Bank Runs and Institutions: The Perils of Intervention," American Economic Review, American Economic Association, vol. 99(4), pages 1588-1607, September.
  10. Alp Simsek & Ricardo Caballero, 2010. "Fire Sales in a Model of Complexity," 2010 Meeting Papers 620, Society for Economic Dynamics.
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  12. Franklin Allen & Douglas Gale, 2000. "Financial Contagion," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 1-33, February.
  13. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  14. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers 319, Bank of England.
  15. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group.
  16. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  17. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
  18. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  19. Amil Dasgupta, 2004. "Financial Contagion Through Capital Connections: A Model of the Origin and Spread of Bank Panics," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1049-1084, December.
  20. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
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