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Financial System Risk and Flight to Quality

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  • Ricardo 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11834.

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Date of creation: Dec 2005
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Handle: RePEc:nbr:nberwo:11834

Note: CF DAE EFG IFM ME
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Cited by:
  1. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2006. "Bubbles and capital flow volatility: Causes and risk management," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(1), pages 35-53, January.
  2. Vasco Cúrdia, 2005. "Monetary Policy under Sudden Stops," International Finance, EconWPA 0510025, EconWPA, revised 02 Nov 2005.
  3. Leon, Jorge, 2010. "International Portfolios and the U.S. Current Account," MPRA Paper 45281, University Library of Munich, Germany.
  4. Coudert, Virginie & Gex, Mathieu, 2010. "Contagion inside the credit default swaps market: The case of the GM and Ford crisis in 2005," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 20(2), pages 109-134, April.

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