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The macroeconomics of financial crises: How risk premiums, liquidity traps and perfect traps affect policy options

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  • Manfred Gärtner

    ()

  • Florian Jung

    ()

Abstract

The paper shows that structural models of the IS-LM and Mundell-Fleming variety have a lot to tell about the macroeconomics of the current global crisis. In addition to demonstrating how the emergence of risk premiums in money and capital markets may drive economies into recessions, it shows the following: (1) Liquidity traps may occur not only when interest rates approach zero but at positive and/or rising rates as well; (2) Fiscal policy works even in a small, open economy under flexible exchange rates when the country is stuck in a liquidity trap; (3) Near the fringe of liquidity traps, the risk arises of perfect traps, in which neither monetary nor fiscal policy works when used in isolation, but policy coordination is called for; and (4) Massive financial crises in the domestic money market may even destabilize the economy.

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File URL: http://www1.vwa.unisg.ch/RePEc/usg/dp2009/DP-0915-Ga.pdf
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Bibliographic Info

Paper provided by Department of Economics, University of St. Gallen in its series University of St. Gallen Department of Economics working paper series 2009 with number 2009-15.

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Length: 26 pages
Date of creation: Jul 2009
Date of revision:
Handle: RePEc:usg:dp2009:2009-15

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Keywords: financial crisis; credit crunch; liquidity trap; zero lower bound; risk premiums; policy options; fiscal policy; monetary policy; open economy.;

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References

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  1. George A. Akerlof, 2009. "How Human Psychology Drives the Economy and Why It Matters," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 91(5), pages 1175-1175.
  2. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
  3. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," NBER Working Papers 10195, National Bureau of Economic Research, Inc.
  4. Mauro Boianovsky, 2003. "The IS-LM Model and the Liquidity Trap Concept: from Hicks to Krugman," Anais do XXXI Encontro Nacional de Economia [Proceedings of the 31th Brazilian Economics Meeting] a13, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
  5. Karl Brunner & Allan H. Meltzer, 1968. "Liquidity Traps for Money, Bank Credit, and Interest Rates," Journal of Political Economy, University of Chicago Press, vol. 76, pages 1.
  6. Krugman, Paul, 2000. "Thinking About the Liquidity Trap," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 221-237, December.
  7. Coenen, Gunter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1071-1101, July.
  8. Mauro Boianovsky, 2004. "The IS-LM Model and the Liquidity Trap Concept: From Hicks to Krugman," History of Political Economy, Duke University Press, vol. 36(5), pages 92-126, Supplemen.
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Cited by:
  1. Manfred Gärtner & Florian Jung, 2010. "Clothes for the Emperor or Can Graduate Schools Learn From Undergraduate Macroeconomics?," University of St. Gallen Department of Economics working paper series 2010 2010-19, Department of Economics, University of St. Gallen.

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