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Financial frictions and the zero lower bound on interest rates: a DSGE analysis

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  • Merola, Rossana

Abstract

Recent developments in Canada, the United Kingdom, the euro area, Japan, Sweden, Switzerland and the United States have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. In this context, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. However, some economists have down-played the risk of hitting the zero lower bound, at least for the US economy. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The financial accelerator mechanism is formalized as in Bernanke, Gertler and Gilchrist (1995). The paper attempts to address three main issues. First, I evaluate whether the zero lower bound -- by limiting the use of the nominal interest rate as a policy instrument -- might hamper the monetary authority from offsetting the negative effects of an adverse shock. Second, I analyze whether price-level targeting, through the stabilization of private sector expectations, might be a better monetary rule than inflation targeting in order to avoid the "liquidity trap". Third, I investigate the effectiveness of fiscal stimulus (namely, an increase in government expenditure) when financial markets are imperfect and the nominal interest rate is close to its zero lower bound. In this context, two questions will be addressed: first, do financial frictions weaken the effect of a fiscal expansion? Second, how are results affected when the zero lower bound is binding? To address these questions, I introduce a negative demand shock and an adverse financial shock. I find that by adopting a price-level targeting rule, the monetary authority might alleviate the recession generated by the interaction of financial frictions and lower-bounded nominal interest rates. Alternatively, an increase in government expenditure has a positive impact on output, but fiscal multipliers are below one, due to a strong crowding-out effect of private consumption. This effect is muted when the nominal interest rate is lower bounded. In analyzing discretionary fiscal policy, this paper does also focus on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 29365.

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Date of creation: Jul 2010
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Handle: RePEc:pra:mprapa:29365

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Keywords: Optimal monetary policy; financial accelerator; lower bound on nominal interest rates; price-level targeting; fiscal stimulus.;

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  1. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary policy alternatives at the zero bound: an empirical assessment," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2004-48, Board of Governors of the Federal Reserve System (U.S.).
  2. Coenen Günter & Orphanides Athanasios & Wieland Volker, 2004. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," The B.E. Journal of Macroeconomics, De Gruyter, De Gruyter, vol. 4(1), pages 1-25, February.
  3. Erceg, Christopher & Lindé, Jesper, 2010. "Is There a Fiscal Free Lunch in a Liquidity Trap?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7624, C.E.P.R. Discussion Papers.
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  6. Buiter, Willem H & Panigirtzoglou, Nikolaos, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2203, C.E.P.R. Discussion Papers.
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Cited by:
  1. Merola, Rossana, 2014. "The role of financial frictions during the crisis: an estimated DSGE model," Dynare Working Papers 33, CEPREMAP.

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