Working Paper: NBER ID: w20275
Authors: Weerachart T. Kilenthong; Robert M. Townsend
Abstract: Pecuniary externalities have regained the interest of researchers as they seek policy interventions and regulations to remedy externality-induced distortions, e.g., balance sheet effects, amplifiers and fire sales. In this paper we go back to first principles and show how to design financial contracts and markets in such a way that ex ante competition can achieve a constrained-efficient allocation. The key as in general equilibrium theory is to extend the commodity space in such a way that bundling, exclusivity and additional markets internalize these pecuniary externalities. We devise in this paper a general way of proceeding that covers as a general case the large variety of example-economies which differ from one another in the particular source of the constraint generating the externality. A key take away from our approach is that we do not need to identify and quantify some policy intervention. With the appropriate ex ante design we can let markets solve the problem.
Keywords: price externalities; segregated exchanges; walrasian equilibrium; market-based solution; collateral; exogenous incomplete markets; moral hazard with retrading; hidden information with retrading; liquidity constraints; fire sales
JEL Codes: D52; D53; D61; D62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| design of financial contracts (G19) | market outcomes (P42) |
| extending the commodity space through bundling and exclusivity (L14) | internalize externalities (D62) |
| internalizing externalities (D62) | constrained-efficient allocations (D61) |
| collateral constraints (D10) | market inefficiencies (G14) |
| collateral constraints (D10) | market prices and allocations (P22) |
| market mechanisms (D47) | resolution of inefficiencies (D61) |