Real Flight to Safety

52 Pages Posted: 18 May 2017 Last revised: 10 Feb 2019

See all articles by Chao Zi

Chao Zi

University of Illinois at Urbana-Champaign

Date Written: February 1, 2019

Abstract

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

Zi, Chao, Real Flight to Safety (February 1, 2019). Available at SSRN: https://ssrn.com/abstract=2970030 or http://dx.doi.org/10.2139/ssrn.2970030

Chao Zi (Contact Author)

University of Illinois at Urbana-Champaign ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

HOME PAGE: http://czi.finance

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