Liquidity Trap and Excessive Leverage

July 21, 2014

Preview Citation

Format: Chicago

Anton Korinek, and Alp Simsek. Liquidity Trap and Excessive Leverage, (USA: International Monetary Fund, 2014) accessed November 23, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

We investigate the role of macroprudential policies in mitigating liquidity traps driven by deleveraging, using a simple Keynesian model. When constrained agents engage in deleveraging, the interest rate needs to fall to induce unconstrained agents to pick up the decline in aggregate demand. However, if the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap. In such an environment, agents' exante leverage and insurance decisions are associated with aggregate demand externalities. The competitive equilibrium allocation is constrained inefficient. Welfare can be improved by ex-ante macroprudential policies such as debt limits and mandatory insurance requirements. The size of the required intervention depends on the differences in marginal propensity to consume between borrowers and lenders during the deleveraging episode. In our model, contractionary monetary policy is inferior to macroprudential policy in addressing excessive leverage, and it can even have the unintended consequence of increasing leverage.

Subject: Asset and liability management, Asset prices, Consumption, Financial services, Income, Liquidity, National accounts, Prices, Real interest rates

Keywords: Aggregate demand, Aggregate demand externality, Asset prices, Consumption, Contractionary monetary policy, Efficiency, Fire-sale externality, Income, Insurance, Interest rate, Leverage, Leveraging motive, Liquidity, Liquidity trap, Macroprudential policy, Pecuniary externality, Real interest rates, WP, Zero lower bound

Publication Details

Pages:

49
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2014/129
Stock No:

WPIEA2014129
ISBN:

9781498370943
ISSN:

1018-5941

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