Liquidity Trap and Excessive Leverage

46 Pages Posted: 20 Mar 2014 Last revised: 25 Jan 2023

See all articles by Anton Korinek

Anton Korinek

University of Virginia; National Bureau of Economic Research (NBER)

Alp Simsek

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2014

Abstract

We investigate the role of macroprudential policies in mitigating liquidity traps driven by deleveraging, using a simple Keynesian model. When constrained agents engage in deleveraging, the interest rate needs to fall to induce unconstrained agents to pick up the decline in aggregate demand. However, if the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap. In such an environment, agents' ex-ante leverage and insurance decisions are associated with aggregate demand externalities. The competitive equilibrium allocation is constrained inefficient. Welfare can be improved by ex-ante macroprudential policies such as debt limits and mandatory insurance requirements. The size of the required intervention depends on the differences in marginal propensity to consume between borrowers and lenders during the deleveraging episode. In our model, contractionary monetary policy is inferior to macroprudential policy in addressing excessive leverage, and it can even have the unintended consequence of increasing leverage.

Suggested Citation

Korinek, Anton and Simsek, Alp, Liquidity Trap and Excessive Leverage (March 2014). NBER Working Paper No. w19970, Available at SSRN: https://ssrn.com/abstract=2411872

Anton Korinek (Contact Author)

University of Virginia

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Alp Simsek

Yale School of Management ( email )

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HOME PAGE: http://https://som.yale.edu/faculty/alp-simsek

National Bureau of Economic Research (NBER) ( email )

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HOME PAGE: http://https://economics.mit.edu/faculty/asimsek

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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