Financial System Risk and Flight to Quality
AbstractWe 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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Date of creation: Dec 2005
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Find related papers by JEL classification:
- E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-12-20 (All new papers)
- NEP-BEC-2005-12-20 (Business Economics)
- NEP-FIN-2005-12-20 (Finance)
- NEP-FMK-2005-12-20 (Financial Markets)
- NEP-MAC-2005-12-20 (Macroeconomics)
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