The paper, written by economists Ricardo Caballero and Arvind Krishnamurthy, studied a flight to quality as market players protected themselves from worst-case assessments of the risks, even though the danger in their own market was small.

It was delivered at a conference on financial markets and systemic risk chaired by Fed Vice Chairman Roger Ferguson.

"Agents respond to uncertainty regarding other markets by requiring financial intermediaries to lock up some capital to devote to their own market's shocks, regardless of what happens in other markets," the paper said.

"While each Knightian agent covers himself against an extreme shock, collectively these actions prevent intermediaries from moving capital across markets to expediently offset shocks as they arrive," the authors said.

Knightian uncertainty -- based on the work of Chicago University economist Frank Knight -- is a theory in economics describing risks that are impossible to measure, which is why market participants overreact in seeking capital protection.

"This inflexibility leaves the economy overexposed to (moderate) aggregate shocks that are manageable by the private sector in the absence of flight to quality," they said.

A central bank, acting as a lender of last resort, can prevent these bottlenecks from developing in capital markets by "committing to intervene during extreme events where the financial intermediaries' capital is depleted."

The authors noted that the Long Term Capital Management rescue sponsored by the Fed after the Russian debt crisis in 1998 was important, not because of its direct effect, "but because it served as a signal of the Fed's readiness to intervene should conditions worsen."

They also said their model had applications for the International Monetary Fund.

"Our model prescribes that the IMF not support the first country hit by a sudden stop, but to commit to intervene once contagion takes place," they said.

Ferguson, who earlier delivered a speech on financial stability, said the Fed was highly selective in choosing which situation in which to insert itself, and that no action was sometimes the best policy.

"There have been plenty of cases where the Fed didn't do anything and it was also proved to be right," he said.

"We are in a dilemma where we want to avoid moral hazard. We want to give the right set of incentives for transparency, liquidity etc, but I'm not quite sure that we have got it right," he said.

Ferguson noted in his speech that central bank actions to prevent financial instability must be conducted with a close eye on its prime policy goals of securing low inflation and sustainable economic growth.