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Federal Reserve Bank of Minneapolis
Working Papers
Liquidity Traps and Monetary Policy: Managing a Credit Crunch
Francisco J. Buera
Juan Pablo Nicolini

We study a model with heterogeneous producers that face collateral and cash-in-advance constraints. These two frictions give rise to a nontrivial financial market in a monetary economy. A tightening of the collateral constraint results in a recession generated by a credit crunch. The model can be used to study the effects on the main macroeconomic variables, and on the welfare of each individual of alternative monetary and fiscal policies following the credit crunch. The model reproduces several features of the recent financial crisis, such as the persistent negative real interest rates, the prolonged period at the zero bound for the nominal interest rate, and the collapse in investment and low inflation in spite of the very large increases in liquidity adopted by the government. The policy implications are in sharp contrast to the prevalent view in most central banks, which is based on the New Keynesian explanation of the liquidity trap.

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Francisco J. Buera & Juan Pablo Nicolini, Liquidity Traps and Monetary Policy: Managing a Credit Crunch, Federal Reserve Bank of Minneapolis, Working Papers 714, 18 Jul 2014.
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Keywords: Liquidity trap; Credit crunch; Collateral constraings; Monetary policy; Ricardian equivalence
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