Working Paper: NBER ID: w11834
Authors: Ricardo J. Caballero; Arvind Krishnamurthy
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.
Keywords: financial system risk; flight to quality; knightian uncertainty; liquidity provision; central bank intervention
JEL Codes: E30; E44; E5; F34; G1; G22; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| knightian uncertainty (D80) | agents' demand for safe financial claims (E41) |
| agents' demand for safe financial claims (E41) | locking up of capital by financial intermediaries (G21) |
| locking up of capital by financial intermediaries (G21) | financial bottlenecks (G21) |
| locking up of capital by financial intermediaries (G21) | market segmentation (M31) |
| agents' demand for safe financial claims (E41) | liquidity shortages (E51) |
| financial system risk (P34) | agents' perceptions of risk (D80) |
| agents' perceptions of risk (D80) | demand for liquidity (E41) |
| central bank intervention (E58) | stabilization of the economy (E63) |
| agents' behavior under uncertainty (D80) | macroeconomic consequences (E60) |
| demand for liquidity (E41) | flight to safer assets (G11) |