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Credit Crises, Precautionary Savings and the Liquidity Trap

  • Guido Lorenzoni


  • Veronica Guerrieri


We use a model a la Bewly-Huggett-Ayagari to explore the effects of a credit crunch on consumer spending. Households borrow and lend to smooth idiosyncratic income shocks facing an exogenous borrowing constraint. We look at the economy response after an unexpected permananent tightening of this constraint. The interest rate drops sharply in the short run and then adjusts to a lower steady state level. This is due to the fact that after the shock a large fraction of agents is far below their target holdings of precautionary savings and this generates a large temporary positive shock to net lending. We then look at the effects on output. Here two opposing forces are present, as households can deleverage in two ways: by consuming less and by working more. We show that under a reasonable parametrization the effect on consumer spending dominates and precautionary behavior generates a recession. If we add nominal rigidities two things happen: (i) the demand-side dominates output dynamics, and (ii) there is a lower bound on the interest rate adjustment. These two elements tend to amplify the recession caused by the credit tightening.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1414.

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Date of creation: 2011
Date of revision:
Handle: RePEc:red:sed011:1414
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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