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Investigating the Zero Lower Bound on the Nominal Interest Rate under Financial Instability

  • Carrillo Julio A.
  • Poilly Céline


This paper introduces a zero lower bound constraint on the nominal interest rate in a financial accelerator model with nominal and real rigidities. We .rst analyze the implicationsfor aggregate dynamics of binding the zero lower bound for shocks that depress the nominalinterest rate. We include a sudden decrease in the value of the business sector net worth and an increase in its returns volatility, as two financial shocks that originate in the endogenous credit market of the model. We then explore the effects of the central bank management of expectations and a fiscal stimulus in a deep recession scenario, where the interest rate initially binds its zero bound. We find that a commitment by the central bank to keep the interest rate low for more time than prescribed by a typical interest rate rule may indeed reduce the volatility of output and inflation. For government purchases, we find a fiscal multiplier greater than one for at least 5 quarters. This is due to the presence of the zero lower bound and the Fisher (1933)’s debt-deflation channel, which implies that government spending may reduce the business sector risk premium and thus the cost of investment.

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Paper provided by Maastricht University, Maastricht Research School of Economics of Technology and Organization (METEOR) in its series Research Memorandum with number 019.

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Date of creation: 2010
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Handle: RePEc:unm:umamet:2010019
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  2. Julio A. CARRILLO & Celine POILLY, 2010. "On the Recovery Path during a Liquidity Trap: Do Financial Frictions Matter for Fiscal Multipliers?," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 2010034, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
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  4. Bodenstein, Martin & Erceg, Christopher & Guerrieri, Luca, 2010. "The Effects of Foreign Shocks When Interest Rates Are at Zero," CEPR Discussion Papers 8006, C.E.P.R. Discussion Papers.
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  8. Robert Amano & Malik Shukayev, 2009. "Risk Premium Shocks and the Zero Bound on Nominal Interest Rates," Staff Working Papers 09-27, Bank of Canada.
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  16. Simon Gilchrist & Egon Zakrajšek, 2011. "Monetary Policy and Credit Supply Shocks," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 59(2), pages 195-232, June.
  17. Carlstrom, Charles T. & Fuerst, Timothy S. & Paustian, Matthias, 2012. "How inflationary is an extended period of low interest rates?," Working Paper 1202, Federal Reserve Bank of Cleveland.
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  19. Andrew Levin & David López-Salido & Edward Nelson & Yack Yun, 2010. "Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound," International Journal of Central Banking, International Journal of Central Banking, vol. 6(1), pages 143-189, March.
  20. Lawrence Christiano & Daisuke Ikeda, 2013. "Leverage Restrictions in a Business Cycle Model," NBER Working Papers 18688, National Bureau of Economic Research, Inc.
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