ABSTRACT
In the classical general equilibrium model, agents keep all their promises, every good is traded, and competition prevents any agent from earning superior returns on investments in financial markets. This chapter introduces the age-old problem of broken promises into the general equilibrium model. It suggests that a new market dynamic emerges, based on collateral as a device to secure promises. The chapter shows that under suitable conditions, in rational expectations equilibrium, some investors will be able to earn higher than normal returns on their investments, and the prices of goods used as collateral will be especially volatile. It illustrates the theoretical points with some of the experiences on Wall Street as director of fixed income research at the firm of Kidder Peabody. The chapter suggests that the main business of Wall Street is to help people make and keep promises.
