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Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium

36 Pages Posted: 27 Sep 2001  

John Geanakoplos

Yale University - Cowles Foundation

Date Written: August 2001

Abstract

The possibility of default limits available liquidity. If the potential default draws nearer, a liquidity crisis may ensue, causing a crash in asset prices, even if the probability of default barely changes, and even if no defaults subsequently materialize.

Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented.

When new information raises the probability and shortens the horizon over which a fixed income asset may default, its drop in price may be much greater than its objective drop in value for two reasons: the drop in value reduces the relative wealth of its natural buyers and also endogenously raises the margin required for its purchase. The liquidity premium rises, and there may be spillovers in which other assets crash in price even though their probability of default did not change.

Keywords: Liquidity, Default, Collateral, Crashes, General Equilibrium, Contracts, Spillover, Liquidity Premium

JEL Classification: D4, D5, D8, D41, D52, D81, D82

Suggested Citation

Geanakoplos, John, Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium (August 2001). Cowles Foundation Discussion Paper No. 1316. Available at SSRN: https://ssrn.com/abstract=284829

John D Geanakoplos (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-3397 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://cowles.econ.yale.edu/P/au/d_gean.htm

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