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A Model of Financial Fragility

Roger Lagunoff () and Stacey Schreft

Game Theory and Information from EconWPA

Abstract: This paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects’ operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crises can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.

JEL-codes: C72 E44 G11 G20 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk, nep-gth, nep-ifn and nep-pke
Date: 1998-03-10, Revised 1998-04-30
Note: Type of Document - .pdf; prepared on IBM PC; to print on HP;
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Related works:
Journal Article: A Model of Financial Fragility (2001) Downloads
Working Paper: A model of financial fragility (1998) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpga:9803001

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