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

Guembel, Alexander and Sussman, Oren (2014) The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises. TSE Working Paper, n. 14-498, Toulouse

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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.

Item Type: Monograph (Working Paper)
Language: English
Date: March 2014
Place of Publication: Toulouse
Uncontrolled Keywords: Contagion, fire sales, financial crisis, financial stability, segmentation, liquidity injection
JEL Classification: F32 - Current Account Adjustment; Short-Term Capital Movements
Divisions: TSE-R (Toulouse), TSM Research (Toulouse)
Institution: Université Toulouse 1 Capitole
Site: UT1
Date Deposited: 09 Jul 2014 17:45
Last Modified: 17 May 2019 14:45
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