Crises: Equilibrium Shifts and Large Shocks
40 Pages Posted: 16 Dec 2016 Last revised: 16 Feb 2019
Date Written: January 2019
A coordination game with incomplete information is played through time. In each period, payoffs depend on a fundamental state and an additional idiosyncratic shock. Fundamentals evolve according to a random walk where the changes in fundamentals (namely common shocks) have a fat tailed distribution. We show that majority play shifts either if fundamentals reach a critical threshold or if there are large common shocks, even before the threshold is reached. The fat tails assumption matters because it implies that large shocks make players more unsure about whether their payoffs are higher than others. This feature is necessary for large shocks to matter.
Keywords: Equilibrium Shift; Global Games; Rank Beliefs; Fat Tails; Hysteresis; Equilibrium Selection; Multiple Equilibria
JEL Classification: C72, D82, E32
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