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Game Theory in Financial Crises

There have been many financial crises in recent decades across many countries. The most recent international economic crisis came in 2008 and hurt the economies of virtually every country including the United States. Some causes of the crisis were runs on investment banks and financial institutions. A run means that many people withdrew cash and investments from these institutions because the people believed that these institutions were not financially sound. These runs coupled with the U.S. housing bubble, risky mortgage loans, lack of strong regulations, and greed helped cultivate an international economic crisis. While we know that these factors helped create the economic crisis, we do not know the exact reason behind the attitude changes that led people to believe that financial institutions were unsound.

Runs on banks delve into the role of game theory in economics and finance. For instance, if people think that a bank is safe, and they believe that other people think the bank is safe, then they will most likely leave their investments deposited in the banks. This is a “good” Nash equilibrium that results in a relative stability. However, if for some reason people start to believe that banks are unsafe, then they will start withdrawing their investments. Other people see these people withdrawing money, and they, in turn, start to withdraw money as well. This creates a positive feedback loop where seeing people withdraw money causes more people to withdraw money which results in seeing more people withdraw money. This cycle settles into a “bad” Nash equilibrium that causes uncertainty in the soundness of the financial system. People’s decisions on whether to leave their investments in these financial institutions are determined by what these people think others will do in the same situation. People’s decisions are reactions to how they think others will behave.



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