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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, EconWPA, revised 30 Apr 1998.
    • Handle: RePEc:wpa:wuwpga:9803001
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    References listed on IDEAS

    as
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    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

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