Macroeconomic Policy during a Credit Crunch

Juan Pablo Nicolini

No 15-2, Economic Policy Paper from Federal Reserve Bank of Minneapolis

Abstract: Most economic models used by central banks prior to the recent financial crisis omitted two fundamental elements: financial markets and liquidity measures. Those models therefore failed to foresee the crisis or understand the policy reaction that followed. In contrast to more orthodox models, we develop a theory in which credit markets and measures of liquidity are central. Our model emphasizes the role of collateral constraints on credit lines and the role of money in transactions, and it can be used to study the effects of alternative monetary policies during and after a financial crisis. A key insight from our approach is that a credit crisis characterized by tightened collateral constraints can cause a bout of deflation that exacerbates the constraints and reduces investment, productivity, employment and economic output. Policymakers can curb deflation and soften the recession by issuing more bonds and money, exactly as U.S. fiscal and monetary officials did in 2008. But our model also reveals an important trade-off in the aftermath of the crisis. Additional liquidity injections necessary to maintain low inflation will partially crowd out private investment and thereby slow economic recovery. The cost of curbing the recession?s depth is thus to extend its duration.

Pages: 6 pages
Date: 2015-02-23
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mfd and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmep:15-2

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