The pecking order of segmentation and liquidity-injection policies in a model of contagious crises

We study a two-country setting in which leveraged investors generate fire-sale externalities, leading to financial crises and contagion. Governments can affect the incidence of financial crisis and the degree of contagion by injecting public liquidity and, additionally, by segmenting the countries’...

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Main Authors: Guembel, A, Sussman, O
Format: Journal article
Published: Oxford University Press 2019
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author Guembel, A
Sussman, O
author_facet Guembel, A
Sussman, O
author_sort Guembel, A
collection OXFORD
description We study a two-country setting in which leveraged investors generate fire-sale externalities, leading to financial crises and contagion. Governments can affect the incidence of financial crisis and the degree of contagion by injecting public liquidity and, additionally, by segmenting the countries’ liquidity markets. We show that segmentation allows a country to avoid contagion and fend off mild financial crises caused by a small shock to its liquidity demand, at the cost of exposing it to more severe financial crises caused by a large shock. We derive a “pecking order” result, whereby segmentation is a second-best measure that coordinated governments should use only when tax capacity constrains them from injecting liquidity. Even when segmentation is welfare-enhancing, it should be applied to public liquidity alone, never restricting the free flow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.
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spelling oxford-uuid:701963e0-d6d5-47a8-a129-d677cf0e44212022-03-26T19:34:56ZThe pecking order of segmentation and liquidity-injection policies in a model of contagious crisesJournal articlehttp://purl.org/coar/resource_type/c_dcae04bcuuid:701963e0-d6d5-47a8-a129-d677cf0e4421Symplectic Elements at OxfordOxford University Press2019Guembel, ASussman, OWe study a two-country setting in which leveraged investors generate fire-sale externalities, leading to financial crises and contagion. Governments can affect the incidence of financial crisis and the degree of contagion by injecting public liquidity and, additionally, by segmenting the countries’ liquidity markets. We show that segmentation allows a country to avoid contagion and fend off mild financial crises caused by a small shock to its liquidity demand, at the cost of exposing it to more severe financial crises caused by a large shock. We derive a “pecking order” result, whereby segmentation is a second-best measure that coordinated governments should use only when tax capacity constrains them from injecting liquidity. Even when segmentation is welfare-enhancing, it should be applied to public liquidity alone, never restricting the free flow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.
spellingShingle Guembel, A
Sussman, O
The pecking order of segmentation and liquidity-injection policies in a model of contagious crises
title The pecking order of segmentation and liquidity-injection policies in a model of contagious crises
title_full The pecking order of segmentation and liquidity-injection policies in a model of contagious crises
title_fullStr The pecking order of segmentation and liquidity-injection policies in a model of contagious crises
title_full_unstemmed The pecking order of segmentation and liquidity-injection policies in a model of contagious crises
title_short The pecking order of segmentation and liquidity-injection policies in a model of contagious crises
title_sort pecking order of segmentation and liquidity injection policies in a model of contagious crises
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