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Pricing systemic crises: monetary and fiscal policy when savers are uncertain

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Abstract

The return on assets depends on the joint behavior of all savers; if all sell the asset simultaneously, then there will be a financial \"Armageddon.\" We assume that risk-neutral savers' information about aggregate investment is too vague to form precise probability estimates, so they have Knightian uncertainty, and thus act to maximize their minimum payoff. Savers invest in a risky asset (economy-wide production) and in a riskless asset (government bonds). In times of high uncertainty, savers hold too many government bonds, lowering output. A monetary policy of lowering the risk-free rate causes savers to save less in total but to invest more in the risky asset, and the policy is shown to be Pareto-improving; but the policy is unable to recapture the optimal allocations. To restore investment and total savings to their optimal levels, the government must also use a fiscal policy of distortionary taxes to discourage current consumption and leisure.

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  • Andreas Lehnert & Wayne Passmore, 1999. "Pricing systemic crises: monetary and fiscal policy when savers are uncertain," Finance and Economics Discussion Series 1999-33, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:1999-33
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    Cited by:

    1. Andreas Lehnert & Wayne Passmore, 1999. "The banking industry and the safety net subsidy," Finance and Economics Discussion Series 1999-34, Board of Governors of the Federal Reserve System (U.S.).
    2. Bank for International Settlements, 2001. "Marrying the macro- and micro-prudential dimensions of financial stability," BIS Papers, Bank for International Settlements, number 01, April.
    3. William Nelson & Wayne Passmore, 2001. "Pragmatic monitoring of financial stability," BIS Papers chapters, in: Bank for International Settlements (ed.), Marrying the macro- and micro-prudential dimensions of financial stability, volume 1, pages 367-384, Bank for International Settlements.

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    Monetary policy; Financial crises;

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