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Recovery is Never Easy - Dynamics and Multiple Equilibria with Financial Arbitrage, Production and Collateral Constraints

Author

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  • Ally Quan Zhang

    (University of Zurich and Swiss Finance Institute)

Abstract

We develop a simple general equilibrium model to study the interactions between financial arbitrage and the real economy under collateral constraints. In good times, arbitrage activities help boost the production sectors by providing external funds to capital investment. However, when exposed to adverse shocks and panic market reactions, arbitrage also amplifies the financial distress and makes it easier for the economy to fall into self-fulfilling crises. Moreover, the possibility of regime switches triggered by exogenous shocks also complicates the path to recovery. The combination of financial distress and pessimistic market anticipation not only slows down the recovery process, but also can trap the economy in a less healthy steady state.

Suggested Citation

  • Ally Quan Zhang, 2017. "Recovery is Never Easy - Dynamics and Multiple Equilibria with Financial Arbitrage, Production and Collateral Constraints," Swiss Finance Institute Research Paper Series 17-02, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1702
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    More about this item

    Keywords

    limit of arbitrage; financial intermediary; segmented markets; financial crises; market liquidity; multiple equilibria; collateral constraints;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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