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Credit Crises, Precautionary Savings and the Liquidity Trap

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  • Guido Lorenzoni

    (MIT)

  • Veronica Guerrieri

    (Chicago)

Abstract

We use a model a la Bewly-Huggett-Ayagari to explore the effects of a credit crunch on consumer spending. Households borrow and lend to smooth idiosyncratic income shocks facing an exogenous borrowing constraint. We look at the economy response after an unexpected permananent tightening of this constraint. The interest rate drops sharply in the short run and then adjusts to a lower steady state level. This is due to the fact that after the shock a large fraction of agents is far below their target holdings of precautionary savings and this generates a large temporary positive shock to net lending. We then look at the effects on output. Here two opposing forces are present, as households can deleverage in two ways: by consuming less and by working more. We show that under a reasonable parametrization the effect on consumer spending dominates and precautionary behavior generates a recession. If we add nominal rigidities two things happen: (i) the demand-side dominates output dynamics, and (ii) there is a lower bound on the interest rate adjustment. These two elements tend to amplify the recession caused by the credit tightening.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1414.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1414

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References

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  1. Thomas Philippon & Virgiliu Midrigan, 2013. "Household Leverage and the Recession," 2013 Meeting Papers 335, Society for Economic Dynamics.
  2. John V. Leahy & Joseph Zeira, 2000. "The Timing of Purchases and Aggregate Fluctuations," NBER Working Papers 7672, National Bureau of Economic Research, Inc.
  3. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
  4. Krusell, Per & Mukoyama, Toshihiko & Sahin, Aysegul, 2009. "Labor-Market Matching with Precautionary Savings and Aggregate Fluctuations," CEPR Discussion Papers 7429, C.E.P.R. Discussion Papers.
  5. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
  6. Veronica Guerrieri & Guido Lorenzoni, 2009. "Liquidity and Trading Dynamics," Econometrica, Econometric Society, vol. 77(6), pages 1751-1790, November.
  7. Gianluca Violante & Greg Kaplan, 2011. "A Model of the Consumption Response to Fiscal Stimulus Payments," 2011 Meeting Papers 243, Society for Economic Dynamics.
  8. Jermann, Urban & Quadrini, Vincenzo, 2009. "Macroeconomic Effects of Financial Shocks," CEPR Discussion Papers 7451, C.E.P.R. Discussion Papers.
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  14. Joseph Gruber & Robert Martin, 2003. "Precautionary savings and the wealth distribution with illiquid durables," International Finance Discussion Papers 773, Board of Governors of the Federal Reserve System (U.S.).
  15. Jesus Fernandez-Villaverde & Dirk Krueger, 2004. "Consumption and Saving over the Life Cycle: How Important are Consumer Durables?," 2004 Meeting Papers 357b, Society for Economic Dynamics.
  16. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  17. Edouard Challe & Xavier Ragot, 2013. "Precautionary Saving over the Business Cycle," PSE Working Papers hal-00843150, HAL.
  18. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  19. Francisco J. Buera & Benjamin Moll, 2012. "Aggregate Implications of a Credit Crunch," NBER Working Papers 17775, National Bureau of Economic Research, Inc.
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