IDEAS home Printed from https://ideas.repec.org/p/wpa/wuwpga/9803001.html
   My bibliography  Save this paper

A Model of Financial Fragility

Author

Listed:
  • Roger Lagunoff

    (Georgetown University)

  • Stacey L. Schreft

    (Federal Reserve Bank of Kansas)

Abstract

This paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects’ operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crises can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.

Suggested Citation

  • Roger Lagunoff & Stacey L. Schreft, 1998. "A Model of Financial Fragility," Game Theory and Information 9803001, University Library of Munich, Germany, revised 30 Apr 1998.
    • Handle: RePEc:wpa:wuwpga:9803001
    Note: Type of Document - .pdf; prepared on IBM PC; to print on HP;
    as

    Download full text from publisher

    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/game/papers/9803/9803001.pdf
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. Kreps, David M & Wilson, Robert, 1982. "Sequential Equilibria," Econometrica, Econometric Society, vol. 50(4), pages 863-894, July.
    2. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, August.
    3. J. M. Keynes, 1937. "The General Theory of Employment," The Quarterly Journal of Economics, Oxford University Press, vol. 51(2), pages 209-223.
    4. Atkeson, Andrew & Rios-Rull, Jose-Victor, 1996. "The balance of payments and borrowing constraints: An alternative view of the Mexican crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 331-349, November.
    5. Franklin Allen & Douglas Gale, 2000. "Financial Contagion," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 1-33, February.
    6. Cooper, R. & Corbae, D., 1997. "Financial Fragility and the Great Depression," Working Papers 97-08, University of Iowa, Department of Economics.
    7. Krasa, Stefan & Villamil, Anne P, 1992. "A Theory of Optimal Bank Size," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 725-749, October.
    8. Lagunoff, Roger & Schreft, Stacey L, 1999. "Financial Fragility with Rational And Irrational Exuberance," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 531-560, August.
    9. Bikhchandani, Sushil & Hirshleifer, David & Welch, Ivo, 1992. "A Theory of Fads, Fashion, Custom, and Cultural Change in Informational Cascades," Journal of Political Economy, University of Chicago Press, vol. 100(5), pages 992-1026, October.
    10. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
    11. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
    12. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
    13. Harold L. Cole & Timothy J. Kehoe, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 91-116.
    14. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-762, November.
    15. Nobuhiro Kiyotaki & John Moore, 1997. "Credit Chains," ESE Discussion Papers 118, Edinburgh School of Economics, University of Edinburgh.
    16. Hiroshi Fujiki & Edward J. Green & Akira Yamazaki, 1999. "Sharing the risk of settlement failure," Working Papers 594, Federal Reserve Bank of Minneapolis.
    17. Abhijit V. Banerjee, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, Oxford University Press, vol. 107(3), pages 797-817.
    18. Frederic S. Mishkin, 1991. "Asymmetric Information and Financial Crises: A Historical Perspective," NBER Chapters,in: Financial Markets and Financial Crises, pages 69-108 National Bureau of Economic Research, Inc.
    19. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279-279.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wpa:wuwpga:9803001. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (EconWPA). General contact details of provider: https://econwpa.ub.uni-muenchen.de .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.