Working Paper

Flight to What? — Dissecting Liquidity Shortages in the Financial Crisis

Abstract: We endogenize the liquidity and the quality of private assets in a tractable incomplete-market model with heterogeneous agents. The model decomposes the convenience yield of government bond into a \"liquidity premium\" (flight to liquidity) and a \"safety premium\" (flight to quality) over the business cycle. When calibrated to match the U.S. aggregate output fluctuations and bond premiums, the model reveals that a sharp reduction in the quality, instead of the liquidity, of private assets was the culprit of the recent financial crisis, consistent with the perception that it was the subprime mortgage problem that triggered the Great Recession. Since the provision of public liquidity endogenously affects the provision of private liquidity, our model indicates that excessive injection of public liquidity during financial crisis can be welfare reducing under either conventional or unconventional policies. In particular, too much intervention for too long can depress capital investment.

Keywords: Liquidity Shortage; Resaleability Constraint; Information Asymmetry; Flight to Liquidity; Flight to Quality; Financial Crisis; Unconventional Policy.;

JEL Classification: E44; E58; G01; G10;

https://doi.org/10.20955/wp.2017.025

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2017-10-10

Number: 2017-25

Pages: 48 pages