The Incentive Channel of Capital Market Interventions

Michael Lee and Daniel Neuhann
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Michael Lee: Federal Reserve Bank of New York
Daniel Neuhann: UT Austin, McCombs School of Business

No 840, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: We develop a tractable dynamic model of collateralized lending in which the degree of adverse selection evolves endogenously due to moral hazard. We use this model to study how government interventions designed to boost liquidity in frozen markets af- fect private incentives to maintain high-quality assets. We show that small interventions can lead to “intervention traps” – expectations concerning future interventions destroy private incentives to improve the quality of collateral, which stunts recovery and war- rants continued market intervention – even when they restore market liquidity. Bigger interventions may lead to faster recoveries, and it may be efficient to continue to inter- vene even after market liquidity is restored. This runs counter to previous findings in static environments where it is optimal to keep interventions as small as possible, and to intervene only when markets are illiquid.

Date: 2018
New Economics Papers: this item is included in nep-ban, nep-dge and nep-fdg
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:840

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