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Financial Stability with Fire Sale Externalities

Author

Listed:
  • Ryuichiro Izumi

    (Department of Economics, Wesleyan University)

  • Yang Li

    (Nankai University)

Abstract

Do policies that aim to mitigate firre sale externalities improve financial stability? We study this question in a model of financial intermediation where banks may sell long-term assets in financial markets subject to cash-in-the-market pricing and bank runs. In the absence of interventions, banks hold more long-term assets than is socially optimal, leading to ineciently large fire sales in a crisis. Regulating banks' short-term liabilities and portfolio choices can mitigate this externality. We show, however, that in economies with high market liquidity, such interventions actually increase financial fragility. In such a case, policymakers must balance the desire to mitigate the externality with financial stability considerations.

Suggested Citation

  • Ryuichiro Izumi & Yang Li, 2021. "Financial Stability with Fire Sale Externalities," Wesleyan Economics Working Papers 2021-002, Wesleyan University, Department of Economics.
  • Handle: RePEc:wes:weswpa:2021-002
    as

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    File URL: http://repec.wesleyan.edu/pdf/rizumi/2021002_izumi.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Fire sale; Pecuniary externalities; Macroprudential policies; Financial fragility;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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