Financial Fragility, Liquidity and Asset Prices

32 Pages Posted: 11 Nov 2008

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Douglas M. Gale

New York University (NYU) - Department of Economics

Date Written: September 2003

Abstract

We define a financial system to be fragile if small shocks have disproportionately large effects. In a model of financial intermediation, we show that small shocks to the demand for liquidity cause either high asset-price volatility or bank defaults or both. Furthermore, as the liquidity shocks become vanishingly small, the asset-price volatility is bounded away from zero. In the limit economy, with no shocks, there are many equilibria; however, the only equilibria that are robust to the introduction of small liquidity shocks are those with non-trivial sunspot activity.

Keywords: financial crisis, financial fragility, liquidity, sunspots

Suggested Citation

Allen, Franklin and Gale, Douglas M., Financial Fragility, Liquidity and Asset Prices (September 2003). NYU Working Paper No. S-FI-03-07. Available at SSRN: https://ssrn.com/abstract=1297772

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

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