Seeking Safety under Uncertainty

This paper studies how a potential shock to the demand for safety or liquidity may affect investors’ portfolio choices and consequently affect the aggregate expected output of the economy. Besides a traditional liquidity shock imposed on investors’ overall consumption pattern, a safe liquidity shock is adopted in this paper such that investors who are hit by the shock need to satisfy a proportion of their minimum safety needs S in an earlier date before personal assets yield final returns. The aggregate expected output in this paper is measured by aggregating the total consumption of all investors over two periods. This paper applies a utility function that reflects investors’ absolute demand for safety. Instead of securing safety by investing in public debt provided by the government or investing in private safe assets provided by the financial intermediaries, investors in this constructed economy can only achieve absolute safety by investing in personal assets that generate a safer return under investors’ own control. Assets that provide personal safety cannot be pledged or transferred; thus, no security can be privately issued, backed by returns from personal assets. The model suggests that shocks to the demand for safety and liquidity affect the aggregate expected output of the economy differently by moving investors’ portfolios in different directions. Both shocks have adverse effects on the aggregate expected output with a different magnitude, depending on a set of factors that affect personal and risky assets’ yields to maturity and their liquidation costs. In comparison, a higher probability of safe liquidity shock leads to higher productive investments that may be liquidated early. When risky investments are far more productive than personal assets, a safety shock causes a larger reduction in the aggregate expected output. Without a subsistence need, investors would invest all endowments in risky and productive assets. A basic safety demand always induces some investment in less productive personal assets to secure a minimum return.