Amplification and Spillover with Financial Arbitrage, Production and Collateral Constraints

Abstract

We construct a dynamic model economy in which households from segmented markets have varying financial asset demands. Intermediaries make arbitrage profit by exploiting the price difference in segmented financial markets. Meanwhile, they are required to separately post their production investment as collateral to support liquidity supply. We show that without uncertainty the intermediaries exhibit self-recovery capacity after negative shocks. We also demonstrate that with uncertainty and agents' inaccurate estimation of future market demand, looser collateral constraints can disturb such self-recovery process and further incur systemic risk through over investment in financial markets and under investment in production. On the contrary, tighter collateral constraints can stabilise the economy and boost the production sector at the cost of market liquidity. The dynamic interaction between the endogenous collateral constraint and liquidity supply turns out to be a powerful transmission mechanism by which the effects of disturbance persist, amplify and spill over to other sectors.

Keywords: collateral constraints, limit of arbitrage, market liquidity, general equilibrium, amplification effect, spillover effect

JEL Classification: D52, D58, G01, G12