Solvency Shocks, Liquidity Shocks, and Fire Sales
Résumé
This paper offers a welfare analysis of fire sales. I develop an equilibrium model of fire sales due to uninsurable idiosyncratic risk, and I study its welfare properties from a second-best perspective. When idiosyncratic shocks are mainly liquidity shocks, asset prices are too low in the private economy. By contrast, when idiosyncratic shocks are mainly solvency shocks, competitive asset prices are too high. I then design an empirical test to determine where the economy stands. I also extend my model to an open economy and show that fire-sale FDI is associated with a deviation from the second-best, but that imposing capital control would make a bad situation worse.