Financial system risk and flight to quality
By: Ricardo J. Caballero [and] Arvind Krishnamurthy
Contributors: Krishnamurthy, Arvind; Massachusetts Institute of Technology. Dept. of Economics
Series: Working paper series / Massachusetts Institute of Technology, Dept. of Economics -- working paper 05-31; Working paper (Massachusetts Institute of Technology. Dept. of Economics) -- no. 05-31.
Publisher: Massachusetts Institute of Technology, Dept. of Economics
Published: 2005
Place of publication: Cambridge, MA
Language: eng
Number of pages: 38
Description: 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. Keywords: Locked collateral, flight to quality, insurance, risk premia, financial intermediaries, lender of last resort, private sector multiplier, collateral shocks, robust control. JEL Classifications: E30, E44, E5, F34, G1, G21, G22, G28.
Notes: "November 21, 2005"--Cover.

Includes bibliographical references (p. 37-38).

Abstract in HTML and working paper for download in PDF available via World Wide Web at the Social Science Research Network.