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The Safety Trap

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  • Ricardo J Caballero
  • Emmanuel Farhi

Abstract

In this article, we provide a model of the macroeconomic implications of safe asset shortages. In particular, we discuss the emergence of a deflationary safety trap equilibrium with endogenous risk premia. It is an acute form of a liquidity trap, in which the shortage of a specific form of assets, safe assets, as opposed to a general shortage of assets, is the fundamental driving force. At the Zero Lower Bound, our model has a Keynesian cross representation, in which net safe asset supply plays the role of an aggregate demand shifter. Essentially, safety traps correspond to liquidity traps in which the emergence of an endogenous risk premium significantly alters the connection between macroeconomic policy and economic activity. “Helicopter drops” of money, safe public debt issuances, swaps of private risky assets for safe public debt, or increases in the inflation target, stimulate aggregate demand and output, while forward guidance is less effective. The safety trap can be arbitrarily persistent, as in the secular stagnation hypothesis, despite the existence of infinitely lived assets.

Suggested Citation

  • Ricardo J Caballero & Emmanuel Farhi, 2018. "The Safety Trap," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(1), pages 223-274.
    • Handle: RePEc:oup:restud:v:85:y:2018:i:1:p:223-274.
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    File URL: http://hdl.handle.net/10.1093/restud/rdx013
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    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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