The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises

Alexander Guembel () and Oren Sussman

No 14-498, TSE Working Papers from Toulouse School of Economics (TSE)

Abstract: We study a two-country setting in which leveraged investors generate fire-sale externalities, leading to financial crises and contagion. Governments can affect the incidence of financial crisis and the degree of contagion by injecting public liquidity and, additionally, by segmenting the countries' liquidity markets. We show that segmentation allows a country to avoid contagion and fend off mild financial crises caused by a small shock to its liquidity demand, at the cost of exposing it to more severe financial crises caused by a large shock. We derive a "pecking order" result, whereby segmentation is a second-best measure that coordinated governments should use only when tax capacity constrains them from injecting liquidity. Even when segmentation is welfare-enhancing, it should be applied to public liquidity alone, never restricting the free ow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.

Keywords: Contagion; fire sales; financial crisis; financial stability; segmentation; liquidity injection (search for similar items in EconPapers)
JEL-codes: F32 G01 (search for similar items in EconPapers)
Date: 2014-03, Revised 2019-03
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Related works:
Journal Article: The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises (2020)
Working Paper: The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:tse:wpaper:28250

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