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Flight to What? — Dissecting Liquidity Shortages in the Financial Crisis

Author

Listed:
  • Dong, Feng

    (Shanghai Jiao Tong University, Shanghai, China.)

  • Wen, Yi

    () (Federal Reserve Bank of St. Louis)

Abstract

We endogenize the liquidity and the quality of private assets in a tractable incomplete-market model with heterogeneous agents. The model decomposes the convenience yield of government bond into a "liquidity premium" (flight to liquidity) and a "safety premium" (flight to quality) over the business cycle. When calibrated to match the U.S. aggregate output fluctuations and bond premiums, the model reveals that a sharp reduction in the quality, instead of the liquidity, of private assets was the culprit of the recent financial crisis, consistent with the perception that it was the subprime mortgage problem that triggered the Great Recession. Since the provision of public liquidity endogenously affects the provision of private liquidity, our model indicates that excessive injection of public liquidity during financial crisis can be welfare reducing under either conventional or unconventional policies. In particular, too much intervention for too long can depress capital investment.

Suggested Citation

  • Dong, Feng & Wen, Yi, 2017. "Flight to What? — Dissecting Liquidity Shortages in the Financial Crisis," Working Papers 2017-25, Federal Reserve Bank of St. Louis, revised 10 Oct 2017.
  • Handle: RePEc:fip:fedlwp:2017-025
    DOI: 10.20955/wp.2017.025
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    File URL: https://doi.org/10.20955/wp.2017.025
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    References listed on IDEAS

    as
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    Keywords

    Liquidity Shortage; Resaleability Constraint; Information Asymmetry; Flight to Liquidity; Flight to Quality; Financial Crisis; Unconventional Policy.;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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