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Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium

Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented. When new information raises the probability a fixed income asset may default, its drop in price may be much greater than its objective drop in value because the drop in value reduces the relative wealth of its natural buyers, who disproportiantely own the asset through leveraged purchases. When the information also shortens the horizon over which the asset might default, its price falls still further because the margin requirement for its purchase endogenously rises. There may be spillovers in which other assets also crash in price even though their probability of default did not change.

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File URL: http://cowles.econ.yale.edu/P/cd/d13a/d1316-r2.pdf
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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1316R2.

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Length: 35 pages
Date of creation: Aug 2001
Date of revision: Jun 2002
Publication status: Published in M. Dewabtripont, L.P. Hansen, and S.J. Turnovsky, eds., Advances in Economics and Econometrics II, Cambridge University Press, 2003, pp. 170-205
Handle: RePEc:cwl:cwldpp:1316r2
Note: CFP 1074.
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