Working Paper: NBER ID: w22444
Authors: Eduardo Dvila; Anton Korinek
Abstract: This paper characterizes the efficiency properties of competitive economies with financial constraints, in which phenomena such as fire sales and financial amplification may arise. We show that financial constraints lead to two distinct types of pecuniary externalities: distributive externalities that arise from incomplete insurance markets and collateral externalities that arise from price-dependent financial constraints. For both types of externalities, we identify three sufficient statistics that determine optimal taxes on financing and investment decisions to implement constrained efficient allocations. We also show that fire sales and financial amplification are neither necessary nor sufficient to generate inefficient pecuniary externalities. We demonstrate how to employ our framework in a number of applications. Whereas collateral externalities generally lead to over-borrowing, the distortions from distributive externalities may easily flip sign, leading to either under- or over-borrowing. Both types of externalities may lead to under- or over-investment.
Keywords: pecuniary externalities; financial frictions; fire sales; financial amplification; optimal taxes
JEL Codes: D62; E44; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial constraints (H60) | distributive externalities (D62) |
| financial constraints (H60) | collateral externalities (D62) |
| distributive externalities (D62) | underborrowing (G51) |
| distributive externalities (D62) | overborrowing (H74) |
| collateral externalities (D62) | increased borrowing capacity (G51) |
| fire sales (G33) | inefficient pecuniary externalities (D61) |
| financial amplification (G32) | inefficient pecuniary externalities (D61) |
| financial constraints (H60) | inefficiencies in asset trading (G14) |
| collateral externalities (D62) | overborrowing (H74) |
| distributive externalities (D62) | underinvestment (G31) |
| distributive externalities (D62) | overinvestment (G31) |