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Monetary Policy in a Financial Crisis

  • Lawrence J. Christiano
  • Christopher Gust
  • Jorge Roldos

What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare? Under what conditions will a cut have the opposite e ffects? We answer these questions in a general class of open economy models, where a financial crisis is modeled as a time when collateral constraints are suddenly binding. We find that when there are frictions in adjusting the level of output in the traded good sector and in adjusting the rate at which that output can be used in other parts of the economy, then a cut in the interest rate is most likely to result in a welfare-reducing fall in output and employment. When these frictions are absent, a cut in the interest rate improves asset positions and promotes a welfare-increasing economic expansion.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9005.

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Date of creation: Jun 2002
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Publication status: published as Christiano, Lawrence J., Christopher Gust and Jorge Roldos. "Monetary Policy In A Financial Crisis," Journal of Economic Theory, 2004, v119(1,Nov), 64-103.
Handle: RePEc:nbr:nberwo:9005
Note: EFG ME
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