Government Safety Net, Stock Market Participation and Asset Prices
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This paper studies the effect on equilibrium prices adventing from the presence
of a safety net during financial crises. It is shown that, by inflating prices with the
insurance provided through its intervention policy, a government might be sowing
the seeds of a crisis that its intention is to prevent in the first place. The model
developed is one with risk-neutral agents facing a static decision problem, under
different (i) frameworks - with and without the possibility of intervention - and (ii)
informational scenarios - imperfect, perfect and common prior information. Intervention
occurs whenever the combined return of those in the market goes below a
certain threshold. By having different frameworks and scenarios, the impact of the
safety net on a diverse class of assets can be studied. Equilibrium prices are shown
to be always higher in the framework with the possibility of intervention, regardless
of the informational scenario. There is a limit on price inflation, however, since an
equilibrium fails to exist in those instances where high prices indicate an intervention
to be imminent. The effect on prices of an increase in the degree of uncertainty
turns out to be dependent on the supply level of the asset.