Journal Article

Investment complementarities, coordination failure, and systemic bankruptcy

Mei Li

in Oxford Economic Papers

Volume 65, issue 4, pages 767-788
Published in print October 2013 | ISSN: 0030-7653
Published online September 2012 | e-ISSN: 1464-3812 | DOI: http://dx.doi.org/10.1093/oep/gps036
Investment complementarities, coordination failure, and systemic bankruptcy

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This paper studies systemic bankruptcy in an economy where: (i) investment complementarities exist; (ii) firms have heterogeneous information about investment returns; and (iii) firms need to finance their investments by borrowing from outside lenders. In a global game setup, I demonstrate that even a small uncertainty about economic fundamentals can be magnified through the uncertainty about other firms’ investment decisions, and can lead to coordination failure, which may be manifested as systemic bankruptcy. Moreover, my model reveals that systemic bankruptcy tends to arise when economic fundamentals are in the intermediate range where coordination matters. High financial leverage of firms greatly increases the severity of systemic bankruptcy. Optimistic beliefs of firms and lenders can alleviate coordination failure, but can also increase the severity of systemic bankruptcy once it happens. High financing costs of lenders worsen coordination failure and increase the severity of systemic bankruptcy by increasing firms’ debt burden.

Keywords: D82; E44

Journal Article.  7215 words.  Illustrated.

Subjects: Information, Knowledge, and Uncertainy ; Money and Interest Rates

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