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Equity Capital, Bankruptcy Risk and the Liquidity Trap

Listed author(s):
  • Oren Levintal

    ()

    (Bar-Ilan University)

This paper explains the emergence of liquidity traps in the aftermath of large-scale financial crises, as happened in the US 1930s, Japan 1990s and recently in the US and Europe. The paper introduces a new balance sheet channel that links equity capital to the risk-free interest rate. When equity capital falls, bankruptcy risks rise. Firms become more vulnerable to external shocks, which makes financial disasters more likely to happen. Consequently, demand for safe assets increases, and the interest rate falls to the lower bound. Simulations show that the interest rate may stay at the lower bound for a long time.

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File URL: http://econ.biu.ac.il/files/economics/working-papers/2012-07.pdf
File Function: Working paper
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Paper provided by Bar-Ilan University, Department of Economics in its series Working Papers with number 2012-07.

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Length: 47 pages
Date of creation: May 2012
Handle: RePEc:biu:wpaper:2012-07
Contact details of provider: Postal:
Faculty of Social Sciences, Bar Ilan University 52900 Ramat-Gan

Phone: Phone: +972-3-5318345
Fax: +972-3-7384034
Web page: http://www.biu.ac.il/soc/ec
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  3. Xavier Gabaix, 2008. "Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-finance," American Economic Review, American Economic Association, vol. 98(2), pages 64-67, May.
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  12. Mitsuhiro Fukao, 2003. "Financial Sector Profitability and Double-Gearing," NBER Chapters,in: Structural Impediments to Growth in Japan, pages 9-36 National Bureau of Economic Research, Inc.
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  16. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  17. Hoshi, Takeo & Kashyap, Anil K, 2010. "Will the U.S. bank recapitalization succeed? Eight lessons from Japan," Journal of Financial Economics, Elsevier, vol. 97(3), pages 398-417, September.
  18. Charles W. Calomiris & Berry Wilson, 2004. "Bank Capital and Portfolio Management: The 1930s "Capital Crunch" and the Scramble to Shed Risk," The Journal of Business, University of Chicago Press, vol. 77(3), pages 421-456, July.
  19. Hoshi, Takeo, 2001. "What Happened to Japanese Banks?," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(1), pages 1-29, February.
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  21. 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.
  22. Hoshi, Takeo & Ito, Takatoshi, 2004. "Financial regulation in Japan: a sixth year review of the Financial Services Agency," Journal of Financial Stability, Elsevier, vol. 1(2), pages 229-243, December.
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