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Financial Crashes versus liquidity trap : the dilemma of monetary policy

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    Abstract

    This paper considers a two-period monetary double auction with incomplete markets of securities and derivatives. Players may share heterogenous beliefs. Short positions in derivatives are constrained by collateral requirements. A central Bank stands ready to lend money or engage in unconventional monetary policy such as quantitative easing. In sharp contrast with the usual picture of equilibrium properties, I show that only three scenarios are compatible with Nash equilibrium condition : 1) either the economy enters a liquidity trap in the first period ; 2) or the money injected by the Central Bank fuels a financial inflation driven by "rational exuberance", whose burst leads to a global crash in the next period, 3) else a significant inflation of commodity prices accompanies the functioning of markets. In particular, neither Friedman's golden rule, nor the Taylor rule turn out to be compatible with the third scenario : Both inevitable lead to a liquidity trap. An example shows that quantitative easing does not provide, in general, any escape from the monetary dilemma.

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    File URL: ftp://mse.univ-paris1.fr/pub/mse/CES2010/10014.pdf
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    Bibliographic Info

    Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number 10014.

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    Length: 40 pages
    Date of creation: Feb 2010
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    Handle: RePEc:mse:cesdoc:10014

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    Keywords: Central Bank; gains to trade; liquidity trap; collateral; default; crash; Taylor rule; deflation; bubble; rational exuberance; heterogenous belief.;

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    1. Giraud, Gael, 2003. "Strategic market games: an introduction," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 355-375, July.
    2. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
    3. Karl Schmedders, Felix Kubler, 2001. "Asset Pricing in Models with incomplete markets and default," Computing in Economics and Finance 2001 58, Society for Computational Economics.
    4. William R. Zame, 1992. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 673, UCLA Department of Economics.
    5. Olivier Blanchard & Giovanni Dell'Ariccia & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 199-215, 09.
    6. Gaël Giraud, 2004. "The limit-price exchange process," Cahiers de la Maison des Sciences Economiques b04118, Université Panthéon-Sorbonne (Paris 1).
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