Working Paper: NBER ID: w12896
Authors: Ricardo J. Caballero; Arvind Krishnamurthy
Abstract: We present a model of optimal intervention in a flight to quality episode. The reason for intervention stems from a collective bias in agents' expectations. Agents in the model make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks, treating the latter uncertainty as Knightian. We show that when aggregate liquidity is low, an increase in uncertainty leads agents to a series of protective actions -- decreasing risk exposures, hoarding liquidity, locking-up capital -- that reflect a flight to quality. However, the conservative actions of agents leave the aggregate economy over-exposed to negative shocks. Each agent covers himself against his own worst-case scenario, but the scenario that the collective of agents are guarding against is impossible. A lender of last resort, even if less knowledgeable than private agents about individual shocks, does not suffer from this collective bias and finds that pledging intervention in extreme events is valuable. The intervention unlocks private capital markets.
Keywords: Flight to Quality; Knightian Uncertainty; Central Bank Intervention; Liquidity Management
JEL Codes: E30; E44; E5F34; 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) | collective bias (D70) |
| collective bias (D70) | protective actions (D18) |
| protective actions (D18) | liquidity shortage (E51) |
| knightian uncertainty (D80) | liquidity shortage (E51) |
| lender of last resort intervention (E58) | alleviate overconservatism (E65) |
| lender of last resort intervention (E58) | restore confidence and liquidity (E44) |
| knightian uncertainty + liquidity shortages (D89) | lender of last resort intervention (E58) |