Leverage and the Financial Accelerator in a Liquidity Trap

Karel Mertens and Morten Ravn

American Economic Review, 2011, vol. 101, issue 3, 413-16

Abstract: We show that the financial accelerator may be very large in a liquidity trap. We study a sticky price model with real estate and a financial friction specified as a collateral constraint. Expectations can lead the economy to a self-fulfilling liquidity trap equilibrium where the lower bound on the nominal interest rate binds. We model these equilibria as stochastic sunspots. As in the Great Depression, a liquidity trap entails house price depreciation and potentially large output losses. Higher leverage implies much larger output losses but at the same time rules out the existence of short-lived liquidity traps.

Date: 2011
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