Abstract: The return on assets depends on the joint behavior of all
savers; if all sell the asset simultaneously, then there will
be a financial "Armageddon." We assume that risk-neutral
savers' information about aggregate investment is too vague to
form precise probability estimates, so they have
Knightian uncertainty, and thus act to maximize their minimum
payoff. Savers invest in a risky asset (economy-wide
production) and in a riskless asset (government bonds). In
times of high uncertainty, savers hold too many government
bonds, lowering output. A monetary policy of lowering the
risk-free rate causes savers to save less in total but to
invest more in the risky asset, and the policy is shown to be
Pareto-improving; but the policy is unable to recapture the optimal
allocations. To restore investment and total savings to their
optimal levels, the government must also use a fiscal policy
of distortionary taxes to discourage current consumption and
leisure.
Keywords: Knightian uncertainty, financial crisis, monetary and fiscal policy
Full paper (185 KB PDF)
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Last update: September 8, 1999
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