NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial System Risk and Flight to Quality

Ricardo Caballero, Arvind Krishnamurthy

NBER Working Paper No. 11834
Issued in December 2005
NBER Program(s):   CF   DAE   EFG   IFM   ME

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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Document Object Identifier (DOI): 10.3386/w11834

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