Liquidity Trap and Excessive Leverage
IMF Working Papers, July 21, 2014
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- Liquidity Trap and Excessive Leverage
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Bibliographic details
- Authors: Anton Korinek, Alp Simsek
- Published: July 21, 2014
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498370943.001
Summary and central findings
- The paper investigates the role of macroprudential policies in mitigating liquidity traps driven by deleveraging using a simple Keynesian model.
- When constrained agents deleverage, the interest rate must fall to induce unconstrained agents to offset the decline in aggregate demand; if the interest rate cannot fall because of the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap.
- Agents' ex-ante leverage and insurance decisions generate aggregate demand externalities in a liquidity-trap environment, making the competitive equilibrium allocation constrained inefficient.
- Welfare can be improved by ex-ante macroprudential policies such as debt limits and mandatory insurance requirements.
- The required size of intervention depends on differences in marginal propensity to consume between borrowers and lenders during the deleveraging episode.
- In the model, contractionary monetary policy is inferior to macroprudential policy for addressing excessive leverage and can unintentionally increase leverage.
Mechanisms and analytical insights
- Deleveraging by constrained agents reduces aggregate demand; to restore demand, the equilibrium requires a lower interest rate so unconstrained agents consume/invest more.
- The zero lower bound (ZLB) prevents sufficiently large declines in the interest rate, producing a liquidity trap characterized by insufficient aggregate demand.
- Ex-ante choices (leverage and insurance) create pecuniary and aggregate demand externalities that are not internalized in the competitive equilibrium.
- Differences in marginal propensity to consume across borrowers and lenders during deleveraging episodes determine the magnitude of the externality and thus the scale of policy intervention needed.
Policy recommendations and comparative evaluation
- Macroprudential interventions recommended:
- Debt limits.
- Mandatory insurance requirements.
- Rationale: Ex-ante macroprudential policies directly address the leverage and insurance choices that create aggregate-demand externalities and constrained inefficiency.
- Comparative assessment: Contractionary monetary policy performs worse than macroprudential policy for correcting excessive leverage and can increase leverage as an unintended consequence.
Subject areas and keywords
- Subject: Asset and liability management, Asset prices, Consumption, Financial services, Income, Liquidity, National accounts, Prices, Real interest rates
- Keywords: aggregate demand, aggregate demand externality, Asset prices, Consumption, contractionary monetary policy, efficiency, fire-sale externality, Income, insurance, interest rate, Leverage, leveraging motive, Liquidity, liquidity trap, macroprudential policy, pecuniary externality, Real interest rates, WP, zero lower bound