We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia rise when the constraint binds, reflecting the capital scarcity. The calibrated model matches the nonlinearity of risk premia during crises and the speed of reversion in risk premia from a crisis back to precrisis levels. We evaluate the effect of three government policies: reducing intermediaries borrowing costs, injecting equity capital, and purchasing distressed assets. Injecting equity capital is particularly effective because it alleviates the equity capital constraint that drives the model's crisis.

The United States is currently engulfed in the most severe financial crisis since the Great Depression. The crisis was triggered by the crash in the real estate “bubble” and amplified by the extreme concentration of risk in a highly leveraged financial sector. Conventional wisdom is that both the bubble and the risk concentration were the result of mistakes in regulatory policy: an expansionary monetary policy during the boom period of the bubble, and failure to reign in the practices of unscrupulous lenders. In this paper we argue that, while correct in some dimensions, this story misses two key structural factors behind the securitization process that supported the real estate boom and the corresponding lever age. First, over the last decade, the US has experienced large and sustained capital inflows from foreigners seeking US assets to store value (Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas 2008 ). Second, especially after the NASDAQ/tech bubble and bust, excess world savings have looked predominantly for safe debt investments. This should not be surprising because a large amount of the capital flow into the US has been from foreign central banks and governments that are not expert investors and are merely looking for a store of value (Krishnamurthy and Annette Vissing-Jorgenson 2008). In this paper we develop a stylized model that captures the essence of this environment. The model accounts for three facts observed during the boom and bust phases of the current crisis. First, during a period of good shocks— which we interpret as the period up to the end

The last few years have seen a significant re-evaluation of the models used to analyze crises in emerging markets. Recent models typically stress financial constraints or distorted financial incentives. While this certainly represents progress, these models share a weakness with the earlier work: neither is uniquely about emerging markets. Adaptations of the Mundell-Fleming model represent Argentina as a Belgium with larger external shocks. Likewise, emerging market models of financial constraints are adaptations of developed economy ones with tighter financial constraints. In our work, we have advocated a model which distinguishes between the financial constraints affecting borrowing and lending among agents within an emerging economy, and those affecting borrowing from foreign lenders. This 'dual liquidity' model offers a parsimonious description of the behavior of firms, governments, and asset prices during financial crises. It also provides prescriptions for optimal policy responses to these crises.

What makes an asset a “safe” asset? We study a model where two countries each issue sovereign bonds to satisfy investors’ safe asset demands. The countries differ in the float of their bonds and the fundamental resources available to rollover debts. A sovereign’s debt is safer if its fundamentals are strong relative to other possible safe assets, not merely strong on an absolute basis. If demand for safe assets is high, a large float enhances safety through a market depth benefit. If demand for safe assets is low, then large debt size is a negative as rollover risk looms large.

US government bonds are considered to be the world's safe store of value, especially during periods of economic turmoil such as the events of 2008. But what makes US government bonds “safe assets”? We highlight coordination among investors, and build a model in which two countries with heterogeneous sizes issue bonds that may be chosen as safe asset. Our model illustrates the benefit of a large absolute debt size as safe asset investors have “nowhere else to go” in equilibrium, and the large country's bonds are chosen as the safe asset. Moreover, the effect becomes stronger in crisis periods.

We integrate a widely accepted version of the separation of ownership and control—Michael Jensen's (1986) free cash flow theory—into a dynamic equilibrium model, and study the effect of imperfect corporate control on asset prices and investment. Aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices, investment, and the cyclical behavior of interest rates and the yield curve. The financial friction causes cash-flow shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. The shocks propagate through large firms and during booms.