Pricing systemic crises: monetary and fiscal policy when savers are uncertain

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.