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Financial frictions and the zero lower bound on interest rates: a DSGE analysis


  • Merola, Rossana


Recent developments in Canada, the United Kingdom, the euro area, Japan, Sweden, Switzerland and the United States have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. In this context, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. However, some economists have down-played the risk of hitting the zero lower bound, at least for the US economy. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The financial accelerator mechanism is formalized as in Bernanke, Gertler and Gilchrist (1995). The paper attempts to address three main issues. First, I evaluate whether the zero lower bound -- by limiting the use of the nominal interest rate as a policy instrument -- might hamper the monetary authority from offsetting the negative effects of an adverse shock. Second, I analyze whether price-level targeting, through the stabilization of private sector expectations, might be a better monetary rule than inflation targeting in order to avoid the "liquidity trap". Third, I investigate the effectiveness of fiscal stimulus (namely, an increase in government expenditure) when financial markets are imperfect and the nominal interest rate is close to its zero lower bound. In this context, two questions will be addressed: first, do financial frictions weaken the effect of a fiscal expansion? Second, how are results affected when the zero lower bound is binding? To address these questions, I introduce a negative demand shock and an adverse financial shock. I find that by adopting a price-level targeting rule, the monetary authority might alleviate the recession generated by the interaction of financial frictions and lower-bounded nominal interest rates. Alternatively, an increase in government expenditure has a positive impact on output, but fiscal multipliers are below one, due to a strong crowding-out effect of private consumption. This effect is muted when the nominal interest rate is lower bounded. In analyzing discretionary fiscal policy, this paper does also focus on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags.

Suggested Citation

  • Merola, Rossana, 2010. "Financial frictions and the zero lower bound on interest rates: a DSGE analysis," MPRA Paper 29365, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:29365

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    References listed on IDEAS

    1. Francisco Covas & Yahong Zhang, 2010. "Price-level versus inflation targeting with financial market imperfections," Canadian Journal of Economics, Canadian Economics Association, vol. 43(4), pages 1302-1332, November.
    2. Svensson, Lars-E-O, 2001. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(S1), pages 277-312, February.
    3. Buiter, Willem H. & Panigirtzoglou, Nikolaos, 1999. "Liquidity Traps: How to Avoid Them and How to Escape Them," CEPR Discussion Papers 2203, C.E.P.R. Discussion Papers.
    4. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
    5. Tony Yates, 2004. "Monetary Policy and the Zero Bound to Interest Rates: A Review," Journal of Economic Surveys, Wiley Blackwell, vol. 18, pages 427-481, July.
    6. Coenen Günter & Orphanides Athanasios & Wieland Volker, 2004. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 4(1), pages 1-25, February.
    7. Cogan, John F. & Cwik, Tobias & Taylor, John B. & Wieland, Volker, 2010. "New Keynesian versus old Keynesian government spending multipliers," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 281-295, March.
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    10. Ben S. Bernanke & Mark Gertler, 1995. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 27-48, Fall.
    11. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2011. "When Is the Government Spending Multiplier Large?," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 78-121.
    12. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 1007-1057.
    13. Christopher Erceg & Jesper Lindé, 2014. "Is There A Fiscal Free Lunch In A Liquidity Trap?," Journal of the European Economic Association, European Economic Association, vol. 12(1), pages 73-107, February.
    14. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
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    16. Frederic S. Miskin & Klaus Schmidt-Hebbel, 2007. "Monetary Policy under Inflation Targeting: An Introduction," Central Banking, Analysis, and Economic Policies Book Series,in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 1, pages 001-022 Central Bank of Chile.
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    18. Giancarlo Corsetti & Keith Kuester & André Meier & Gernot J. Müller, 2010. "Debt Consolidation and Fiscal Stabilization of Deep Recessions," American Economic Review, American Economic Association, vol. 100(2), pages 41-45, May.
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    22. repec:cje:issued:v:50:y:2017:i:3:p:660-684 is not listed on IDEAS
    23. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2017. "The effects of foreign shocks when interest rates are at zero," Canadian Journal of Economics, Canadian Economics Association, vol. 50(3), pages 660-684, August.
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    26. Jesús Fernández-Villaverde, 2010. "Fiscal Policy in a Model with Financial Frictions," American Economic Review, American Economic Association, vol. 100(2), pages 35-40, May.
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    More about this item


    Optimal monetary policy; financial accelerator; lower bound on nominal interest rates; price-level targeting; fiscal stimulus.;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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