Ambiguity aversion and amplification of financial crisis

We introduce Knightian uncertainty into a standard global game framework to propose a new amplification mechanism of financial crises. In the model, ambiguity-averse speculators are uncertain about the accuracy of a public signal. They shift more weight to the public signal when it is deteriorating. In the equilibrium, a public signal cut-off characterises the coordination attack against the regime. Below (above) the cut-off, there is a weak (strong) regime in which the public signal is more (less) pronounced. For an outside observer, there is an asymmetric amplification of the financial crisis. We derive the magnitude of amplification and study its property. To enhance financial stability, a policymaker may clarify the source of a public rumour.