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 economic 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.