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.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
12896.
Length: Date of creation: Feb 2007 Date of revision: Handle: RePEc:nbr:nberwo:12896
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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 G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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Larry G. Epstein & Martin Schneider, 2001.
"Recursive Multiple-Priors,"
RCER Working Papers
485, University of Rochester - Center for Economic Research (RCER).
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