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Equity Capital, Bankruptcy Risk and the Liquidity Trap

  • 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
Date of revision:
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
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Web page: http://www.biu.ac.il/soc/ec
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  2. Auerbach, Alan J. & Obstfeld, Maurice, 2012. "The Case for Open-Market Purchases in a Liquidity Trap," Center for International and Development Economics Research, Working Paper Series qt4tm5h0s3, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
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  4. 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.
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  17. 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.
  18. Olivier Jeanne & Lars E. O. Svensson, 2007. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," American Economic Review, American Economic Association, vol. 97(1), pages 474-490, March.
  19. Douglas Gale & Onur Özgür, 2005. "Are Bank Capital Ratios too High or too Low? Incomplete Markets and Optimal Capital Structure," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 690-700, 04/05.
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