Financial Crises as a Phenomenon of Multiple Equilibria and How to Select among Them

Abstract

AbstractWhen equilibrium is indeterminate (i.e., not unique), applied theory often obtains uniqueness either via ad hoc sunspots or via global games. This paper highlights the relative merits of a third selection mechanism—best‐response dynamics (BRD)—in the context of various financial crisis frameworks. For example, in the context of a bank run, selection via BRD is preferred (to ad hoc sunspots) because it provides an explicit coordination narrative and (to global games) because it accounts for the fact that depositors realistically may decide to join or leave a bank's queue upon observing its length.