Financial System Risk and Flight to Quality

Ricardo Caballero () and Arvind Krishnamurthy

No 11834, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We present a model of flight to quality episodes that emphasizes financial system risk and the Knightian uncertainty surrounding these episodes. In the model, agents are uncertain about the probability distribution of shocks in markets different from theirs, treating such uncertainty as Knightian. Aversion to this uncertainty generates demand for safe financial claims. It also leads agents to require financial intermediaries to lock-up capital to cover their own markets' shocks in a manner that is robust to uncertainty over other markets. These actions are wasteful in the aggregate and can trigger a financial accelerator. A lender of last resort can unlock private capital markets to stabilize the economy during these episodes by committing to intervene should conditions worsen.

JEL-codes: E30 E44 E5 F34 G1 (search for similar items in EconPapers)
Date: 2005-12
New Economics Papers: this item is included in nep-bec, nep-fin, nep-fmk and nep-mac
Note: CF DAE EFG IFM ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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