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Discussion Paper

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The possibility of default limits available liquidity. If the potential default draws nearer, a liquidity crisis may ensue, causing a crash in asset prices, even if the probability of default barely changes, and even if no defaults subsequently materialize. Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented. When new information raises the probability and shortens the horizon over which a fixed income asset may default, its drop in price may be much greater than its objective drop in value for two reasons: the drop in value reduces the relative wealth of its natural buyers and also endogenously raises the margin required for its purchase. The liquidity premium rises, and there may be spillovers in which other assets crash in price even though their probability of default did not change.

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