Real Flight to Safety
52 Pages Posted: 18 May 2017 Last revised: 10 Feb 2019
Date Written: February 1, 2019
In postwar U.S. data, recessions are often accompanied by rising macroeconomic uncertainty and a falling private sector investment share. I rationalize this pattern in a two-sector general equilibrium model that features exogenous variations in uncertainty and endogenous allocation of capital between the private and public sectors. The model demonstrates a risk-based mechanism that not only produces the “flight to safety” phenomenon in financial markets but also drives compositional changes in aggregate investment. With this distinctive mechanism, the model predicts that: (i) there is a positive (negative) relationship between the public (private) sector investment rate and firms’ risk premiums; (ii) an increase in aggregate uncertainty in the private sector is associated with a decrease in the private sector investment share as well as a decrease in the real short rate; (iii) controlling for uncertainty, a larger private sector investment share is associated with a lower real short rate. These predictions are consistent with the empirical evidence.
Keywords: Flight to Safety, Real Investment, Uncertainty
JEL Classification: E44, G00, G18
Suggested Citation: Suggested Citation