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Collateral Constraints and the Interest Rate

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  • Donal Smith

Abstract

This paper establishes a transmission mechanism between credit constraints and persistently low real interest rates. In doing so, it establishes a link between two strands of macroeconomic literature that have become prominent since the nancial crisis; nancial frictions literature and zero lower bound literature. In order to analyse the credit constraints and interest rate interaction, the paper presets a perpetual youth overlapping generations model, which is extended to incorporate an endogenous nancial friction in the form of a collateral constraint. Analytical expressions and elementary diagrams are presented to illustrate the results of the model. It is found that a tightening of the nancial friction reduces the steady state rate of interest, and that non-lineaities exist in this relationship. This result occurs endogenously in the model subsequent to a change in the constraint. The model also supports hypotheses from the secular stagnation literature by way of illustrating that population ageing and higher debt levels canleave an economy more likely to encounter episodes of persistent low interest rates.

Suggested Citation

  • Donal Smith, 2015. "Collateral Constraints and the Interest Rate," Discussion Papers 15/22, Department of Economics, University of York.
  • Handle: RePEc:yor:yorken:15/22
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    References listed on IDEAS

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    More about this item

    Keywords

    Financial Frictions; Overlapping Generations; Interest Rate;

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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