Financial Fragility, Liquidity and Asset Prices

A financial system is fragile if a small shock has a large effect. Sunspot equilibria, where the endogenous variables depend on extrinsic uncertainty, provide an extreme illustration. However, fundamental equilibria, where outcomes depend only on intrinsic uncertainty, can also be fragile. We study the relationship between sunspot equilibria and fundamental equilibria in a model of financial crises. The amount of liquidity is endogenously chosen and determines asset prices. The model has multiple equilibria, but only some of these are the limit of fundamental equilibria when the fundamental uncertainty becomes vanishingly small. We show that under certain conditions the only robust equilibria are those in which extrinsic uncertainty gives rise to asset price volatility and Þnancial crises.