We examine whether a loss in confidence can bring about a liquidity trap recession in model with nominal rigidities that features a housing sector and credit frictions. Our analysis is motivated by the recent recession in the US during which there was an unusually large decline in economic activity, brief deflation, short-term interest rates close or at the zero lower bound, and significant financial turmoil. These characteristics have been much discussed in the popular press and amongst academics but as of yet, there is little or no consensus on the sources of the crisis and on the appropriate policy responses.
Recent models of the interactions between financial frictions and monetary policy at the zero lower bound have been based on various assumptions regarding the source of the liquidity trap recession. In Gertler and Karadi (2009), exogenous destruction of the physical capital stock decreases asset prices and causes a balance sheet driven downturn. Del Negro, Eggertson, Ferrero and Kiyotaki (2010) consider an exogenous tightening of borrowing constraints faced by capital producing entrepreneurs. Curdia and Woodford (2010) focus on an exogenous temporary increase in credit spreads. In Eggertson and Krugman (2010), borrowing constraints for impatient households tighten exogenously. All these studies explain the observed correlation between zero nominal interest rates and financial turmoil as directly resulting from an exogenous shock to credit conditions or asset prices.
We explore the hypothesis that a sudden deterioration in expectations has affected credit conditions and asset prices, driving the economy in a liquidity trap. We present a model in which a rational self-fulfilling loss in confidence can occur because monetary policy may lose its ability to stabilize the economy. This happens when policy becomes involuntarily overly tight as the interest rate instrument reaches the zero lower bound and there is deflation after agents act upon their expectations.
Financial market distress, rather than being the direct cause of the recession, acts only as an endogenous propagation mechanism, albeit a very strong one. In our model environment, financial frictions affect only a relatively small sector in the economy directly. Yet, tightening credit conditions play a large role for the dynamics of an expectations driven liquidity trap. Thus, our model is consistent with the fact that financial frictions seem to have been much more important in this recession than in most previous ones.
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Credit Channels in a Liquidity Trap
