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Financial Stress and Liquidity Traps

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  • Aikman, David Llewelyn

    (University of Warwick)

Abstract

Motivated by the bubble-collapse cycle witnessed in Japanese asset prices since the late 1980s, this paper examines how a financial crisis influences the power of monetary policy. We construct a simple macroeconomic model based on the microfoundations of Holmstrom and Tirole (1997) to analyse the effect of three types of financial stress on the nature of the equilibrium: a credit crunch; an adverse collateral shock; and a monitoring cost shock. Perhaps surprisingly, we find that the power of monetary policy is, if anything, heightened in a credit crunch; higher monitoring costs however work in the opposite direction, suggesting a need for more aggressive stabilisation policy in the face of financial shocks.

Suggested Citation

  • Aikman, David Llewelyn, 2002. "Financial Stress and Liquidity Traps," Royal Economic Society Annual Conference 2002 2, Royal Economic Society.
  • Handle: RePEc:ecj:ac2002:2
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