Financial System Risk and Flight to Quality
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 market 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 collateral and stabilize the economy during negative shocks by committing to intervene should conditions worsen.
Ricardo Caballero, Arvind Krishnamurthy
Caballero, Ricardo, and Arvind Krishnamurthy. 2005. Financial System Risk and Flight to Quality.LINK