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

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  • Alexander Guembel
  • Oren Sussman
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 flow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.

Suggested Citation

  • Alexander Guembel & Oren Sussman, 2020. "The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 87(3), pages 1296-1330.
    • Handle: RePEc:oup:restud:v:87:y:2020:i:3:p:1296-1330.
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    File URL: http://hdl.handle.net/10.1093/restud/rdz015
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    More about this item

    Keywords

    Contagion; Fire sales; Financial crisis; Financial stability; Segmentation; Liquidity injection;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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