Liquidity Traps and Monetary Policy: Managing a Credit Crunch

Abstract

We study a model with heterogeneous producers that face collateral and cash in advance constraints. These two frictions give rise to a non-trivial financial market in a monetary economy. A tightening of the collateral constraint results in a credit-crunch generated recession. The model can suitable be used to study the effects on the main macroeconomic variables -and on welfare of each individual -of alternative monetary -and fiscal -policies following the credit crunch. The model reproduces several features of the recent financial crisis, like the persistent negative real interest rates, the prolonged period at the zero bound for the nominal interest rate, the collapse in investment and low inflation, in spite of the very large increases of liquidity adopted by the government. The policy implications are in sharp contrast with the prevalent view in most Central Banks, based on the New Keynesian explanation of the liquidity trap. * Federal Reserve Bank of Chicago and NBER; fjbuera@econ.ucla.edu. † Federal Reserve Bank of Minneapolis and Universidad Di Tella; juanpa@minneapolisfed.org. ‡ We want to thank

Optimal Monetary Policy in a Liquidity Trap With Heterogeneous Agents

“…This framework has been studied with flexible prices to provide analytical proof, in line with many contributions considering financial frictions (Buera and Nicolini (2014); Bachetta et al (2015) or Azariadis, Bullard, Singh, and Suda (2015) among others). The consideration of sticky prices is a natural extension and would need a more quantitative analysis.…”

“…In monetary debates, the claim that the size of the central bank balance sheet has real effects is often attributed to Friedman and Schwartz (1963), after their analysis of monetary policy in the Great Depression (see Buera and Nicolini (2014) for a recent paper). The fact that introducing agents' heterogeneity confirms the Friedman and Schwartz view about the role of the central bank balance sheet should not come as a surprise.…”

“…Recent papers have studied the positive effect of money injection in a liquidity trap in models where financial frictions mainly affect firms or entrepreneurs and limit the efficiency of capital allocation (Buera and Nicolini (2014); Bachetta, Benhima, and Kalantzis (2015)). These papers do not consider optimal policies.…”