Financial Fragility, Liquidity and Asset Prices

Abstract

We define a financial system to be fragile if small shocks have disproportionately large effects. In a model of financial intermediation, we show that small shocks to the demand for liquidity cause either high asset-price volatility or bank defaults or both. Furthermore, as the liquidity shocks become vanishingly small, the asset-price volatility is bounded away from zero. In the limit economy, with no shocks, there are many equilibria; however, the only equilibria that are robust to the introduction of small liquidity shocks are those with non-trivial sunspot activity.