COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1316RR

Liquidity, Default and Crashes:
Endogenous Contracts in General Equilibrium

John Geanakoplos

Revised June 2002

 Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented.

When new information raises the probability a fixed income asset may default, its drop in price may be much greater than its objective drop in value because the drop in value reduces the relative wealth of its natural buyers, who disproportiantely own the asset through leveraged purchases. When the information also shortens the horizon over which the asset might default, its price falls still further because the margin requirement for its purchase endogenously rises. There may be spillovers in which other assets also crash in price even though their probability of default did not change.

Keywords: Liquidity, default, collateral, crashes, general equilibrium, contracts, spillover, liquidity premium

JEL Classification: D4, D5, D8, D41, D52, D81, D82