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 quot;Armageddon.quot; We assume that risk-neutral savers' information about aggregate investment is too vague to form precise probability estimates, so that 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 is shown to be Pareto-improving, but to be 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