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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.

Suggested Citation

  • Manfred Gärtner & Florian Jung, 2009. "The macroeconomics of financial crises: How risk premiums, liquidity traps and perfect traps affect policy options," University of St. Gallen Department of Economics working paper series 2009 2009-15, Department of Economics, University of St. Gallen.
    • Handle: RePEc:usg:dp2009:2009-15
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    File URL: http://ux-tauri.unisg.ch/RePEc/usg/dp2009/DP-0915-Ga.pdf
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    References listed on IDEAS

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    1. Krugman, Paul, 2000. "Thinking About the Liquidity Trap," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 221-237, December.
    2. Svensson, Lars-E-O, 2001. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(S1), pages 277-312, February.
    3. Coenen, Guenter & Wieland, Volker, 2003. "The Zero-Interest-Rate and the Role of the Exchange Rate for Monetary Policy in Japan," CFS Working Paper Series 2003/09, Center for Financial Studies (CFS).
    4. 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.
    5. 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.
    6. 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.
    7. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 145-166, Fall.
    8. 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.
    9. Wyplosz, Charles, 2009. "Macroeconomics After the Crisis," Walter Adolf Jöhr Lecture 2009, University of St. Gallen, School of Economics and Political Science, Institute of Economics (FGN-HSG).
    10. 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(1), pages 1-1.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. repec:kap:iaecre:v:17:y:2011:i:1:p:12-27 is not listed on IDEAS
    2. 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.
    3. Manfred Gärtner & Florian Jung, 2011. "The Macroeconomics of Financial Crises: How Risk Premiums and Liquidity Traps Affect Policy Options," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 17(1), pages 12-27, February.

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    More about this item

    Keywords

    financial crisis; credit crunch; liquidity trap; zero lower bound; risk premiums; policy options; fiscal policy; monetary policy; open economy.;
    All these keywords.

    JEL classification:

    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F01 - International Economics - - General - - - Global Outlook
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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