## Liquidity Trap and Excessive Leverage

_IMF Working Papers, July 21, 2014_

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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

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### 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

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/liquidity-trap-and-excessive-leverage-41769_