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Credit Channels in a Liquidity Trap

  • Mertens, Karel
  • Ravn, Morten O

We study liquidity trap dynamics driven by nonfundamental shifts in expectations in a model with nominal rigidities, housing, credit frictions and a Taylor rule. Highly leveraged borrowing through nominal debt backed by real estate collateral greatly magnifies the decline in output and house prices during a liquidity trap recession. The amplification mechanism is much smaller when there is no feedback from house prices to the borrowing constraint, when debt is real rather nominal, and when leverage is small. We argue that the liquidity trap dynamics share some important features with the recent US recession and that high levels of leverage may have made the economy sensitive to expectations induced liquidity traps.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8322.

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Date of creation: Apr 2011
Date of revision:
Handle: RePEc:cpr:ceprdp:8322
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  1. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
  2. Lawrence J. Christiano & Martin Eichenbaum & Sergio Rebelo, 2010. "When is the government spending multiplier large?," FRB Atlanta CQER Working Paper 2010-01, Federal Reserve Bank of Atlanta.
  3. Vasco Cúrdia & Michael Woodford, 2009. "Conventional and unconventional monetary policy," Staff Reports 404, Federal Reserve Bank of New York.
  4. Farmer, Roger E.A. & Waggoner, Daniel F. & Zha, Tao, 2011. "Minimal state variable solutions to Markov-switching rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 35(12), pages 2150-2166.
  5. repec:oup:qjecon:v:123:y:2008:i:4:p:1415-1464 is not listed on IDEAS
  6. Karel Mertens & Morten O. Ravn, 2011. "Leverage and the Financial Accelerator in a Liquidity Trap," American Economic Review, American Economic Association, vol. 101(3), pages 413-16, May.
  7. Mertens, Karel & Ravn, Morten O, 2010. "Fiscal Policy in an Expectations Driven Liquidity Trap," CEPR Discussion Papers 7931, C.E.P.R. Discussion Papers.
  8. Hanushek, Eric A & Quigley, John M, 1980. "What Is the Price Elasticity of Housing Demand?," The Review of Economics and Statistics, MIT Press, vol. 62(3), pages 449-54, August.
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