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Collective Risk Management in a Flight to Quality Episode

Authors

  • RICARDO J. CABALLERO,

  • ARVIND KRISHNAMURTHY

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    • Caballero is from MIT and NBER. Krishnamurthy is from Northwestern University and NBER. We are grateful to Marios Angeletos, Olivier Blanchard, Phil Bond, Craig Burnside, Jon Faust, Xavier Gabaix, Jordi Gali, Michael Golosov, Campbell Harvey, William Hawkins, Burton Hollifield, Bengt Holmstrom, Urban Jermann, Dimitri Vayanos, Ivan Werning, an associate editor and anonymous referee, as well as seminar participants at Atlanta Fed Conference on Systematic Risk, Bank of England, Central Bank of Chile, Columbia, DePaul, Imperial College, London Business School, London School of Economics, Northwestern, MIT, Wharton, NY Fed Liquidity Conference, NY Fed Money Markets Conference, NBER Economic Fluctuations and Growth meeting, NBER Macroeconomics and Individual Decision Making Conference, Philadelphia Fed, and University of British Columbia Summer Conference for their comments. Vineet Bhagwat, David Lucca, and Alp Simsek provided excellent research assistance. Caballero thanks the NSF for financial support. This paper covers the same substantive issues as (and hence replaces) “Flight to Quality and Collective Risk Management,” NBER WP # 12136.


ABSTRACT

Severe flight to quality episodes involve uncertainty about the environment, not only risk about asset payoffs. The uncertainty is triggered by unusual events and untested financial innovations that lead agents to question their worldview. We present a model of crises and central bank policy that incorporates Knightian uncertainty. The model explains crisis regularities such as market-wide capital immobility, agents' disengagement from risk, and liquidity hoarding. We identify a social cost of these behaviors, and a benefit of a lender of last resort facility. The benefit is particularly high because public and private insurance are complements during uncertainty-driven crises.

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