Credit Traps

Abstract

This paper studies the limitations of the ‘credit channel’ in transmitting monetary policy into real economic outcomes. We focus on one particular failure of the credit channel in which although the central bank is infusing money into the banking system, liquidity remains stuck in banks and is not lent out. We use the term ‘credit traps’ to describe such situations and show how they can arise due to the interplay between financing frictions, liquidity, and collateral values. Our analysis offers a characterization of the problems created by credit traps as well as potential solutions and policy implications. Among these, the analysis shows how quantitative easing and fiscal policy acting in conjunction with monetary policy may be useful in increasing bank lending. Further, small shifts in monetary or fiscal policy can lead to collapses in lending, aggregate investment, and collateral prices.

Keywords: Liquidity, Credit Channel of Monetary Policy, Collateral, Banking

JEL Classification: G21, G33, E51, E63