A Model of Financial Fragility

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 crisis 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. * Lagunoff, Department of Economics, Georgetown University, Washington, D.C., 20057, 202-687-1510, lagunofr@gusun.georgetown.edu; Schreft, Research Department, Federal Reserve Bank of Kansas City, Kansas City, MO 64198, 816-881-2581, sschreft@frbkc.org. The authors wish to thank Harold Cole, Ed Green, Peter Hartley, Patrick Kehoe, Narayana Kocherlakota, Jeffrey Lacker, Harald Uhlig, Anne Villamil, and participants of the 1998 Texas Monetary Conference, the 1998 Summer Meetings of the Econometric Society, the 1998 Meetings of the Society of Economic Dynamics, the 1998 Northwestern Summer Macro Workshop, and numerous Federal Reserve System and university seminars for many helpful comments. Barak Hoffman provided valuable research assistance. The views expressed in this paper are not necessarily those of the Federal Reserve Bank of Kansas City or the Federal Reserve System. Financial fragility is, to a large extent, an unavoidable consequence of a dynamic capitalistic economy. Its fundamental sources ... cannot be eliminated by government intervention, and attempts to do so may create more instability than they prevent. [Calomiris, 1995, p. 254] [T]he Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy. [Friedman, 1962, p. 38] If [someone] would only fully specify any one financial-fragility model ... , perhaps we could think more clearly about the potential scope of the argument. [Melitz, 1982, p. 47]

DOI: 10.1006/jeth.2000.2733

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@article{Lagunoff2001AMO, title={A Model of Financial Fragility}, author={Roger Lagunoff and Stacey L. Schreft}, journal={J. Economic Theory}, year={2001}, volume={99}, pages={220-264} }