Credit Spreads and the Zero Bound on Interest Rates

Nominal interest rates typically approach the zero-lower bound during a financial crisis. This is a constraint on optimal monetary policy: In a model with financial frictions, policy would set negative nominal interest rates in response to increases in credit spreads. We find that fiscal policy can mitigate the effect of the restriction imposed by the zero bound but cannot overcome it without incurring additional costs. The zero bound is a more severe constraint for policy due to inefficiencies in financial markets rather than to price rigidities.