The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises

Sussman, Oren and Guembel, Alexander The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises. The Review of Economic Studies. (Accepted)

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Abstract

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 of 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 ow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.

Item Type: Article
Keywords: Contagion, fire sales, financial crisis, financial stability, segmentation, liquidity injection, finance
Subject(s): Finance
Date Deposited: 07 Mar 2019 16:40
Last Modified: 07 Mar 2019 16:40
Funders: n/a
URI: http://eureka.sbs.ox.ac.uk/id/eprint/7310

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