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Collective risk management in a flight to quality episode

Author: Ricardo J Caballero; Arvind Krishnamurthy; National Bureau of Economic Research.
Publisher: Cambridge, Mass. : National Bureau of Economic Research, 2007.
Series: Working paper series (National Bureau of Economic Research), no. 12896.
Edition/Format:   eBook : Document : EnglishView all editions and formats
Database:WorldCat
Summary:
"We present a model of optimal intervention in a flight to quality episode. The reason for intervention stems from a collective bias in agents' expectations. Agents in the model make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks, treating the latter uncertainty as Knightian. We show that when  Read more...
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Material Type: Document, Internet resource
Document Type: Internet Resource, Computer File
All Authors / Contributors: Ricardo J Caballero; Arvind Krishnamurthy; National Bureau of Economic Research.
OCLC Number: 84000311
Description: 1 online resource (1 volume).
Series Title: Working paper series (National Bureau of Economic Research), no. 12896.
Responsibility: Ricardo J. Caballero, Arvind Krishnamurthy.

Abstract:

"We present a model of optimal intervention in a flight to quality episode. The reason for intervention stems from a collective bias in agents' expectations. Agents in the model make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks, treating the latter uncertainty as Knightian. We show that when aggregate liquidity is low, an increase in uncertainty leads agents to a series of protective actions -- decreasing risk exposures, hoarding liquidity, locking-up capital -- that reflect a flight to quality. However, the conservative actions of agents leave the aggregate economy over-exposed to negative shocks. Each agent covers himself against his own worst-case scenario, but the scenario that the collective of agents are guarding against is impossible. A lender of last resort, even if less knowledgeable than private agents about individual shocks, does not suffer from this collective bias and finds that pledging intervention in extreme events is valuable. The intervention unlocks private capital markets"--NBER website.

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