Empirical and Normative Economics: A Game Theoretic Approach

Abstract

An important problem in public finance is the interaction of public finance with private finance — particularly when private financial markets crash, then bank runs occur, and a central bank needs to bail out the banks to prevent an eco nomic depression. Historically, private financial markets have periodically crashed (financial bubbles); and then public finance (central bank reserves) have sometimes bailed out banks, to prevent a depression. The reason this pattern (of a lack of regulation to prevent financial bubbles, but then bailing out banks) has historically recurred has been the use of an idealized economic theory of “perfect market” — used in economic policy to avoid appropriate regulation of a financial market. In this research, we formulate a “game-theoretic approach” to include financial regulation as an explicit part of the model of a financial market. Future research direction from this game approach can extend the traditional “endogenous economic theory of markets” into an empirical modeling technique — which can ground economic theory in the real history of market instabilities.