Liquidity Traps and Monetary Policy: Managing a Credit Crunch

Francisco Buera

Juan Pablo Nicolini, Senior Research Economist

February 2017 | Federal Reserve Bank of Minneapolis Staff Report 540

We study a model with heterogeneous producers that face collateral and cash-in-advance constraints. A tightening of the collateral constraint results in a credit-crunch-generated recession that reproduces several features of the ļ¬nancial crisis that unraveled in 2007 in the United States. The model can be used to study the effects of the credit-crunch on the main macroeconomic variables and the impact of alternative policies. The policy implications regarding forward guidance are in contrast with the prevalent view in most central banks, based on the New Keynesian explanation of the liquidity trap.

Related: Staff Report 541: Online Appendix for Liquidity Traps and Monetary Policy: Managing a Credit Crunch