Financial Crisis, Equity Capital and the Liquidity Trap

Abstract

This paper explains the emergence of liquidity traps in the aftermath of large-scale financial crises. It establishes a link between the equity capital of the corporate sector and the risk-free interest rate. When equity capital falls, the risk-free interest rate declines because bonds become riskier and investors seek safer assets. If the fall in equity capital is too large, the risk-free interest rate drops to its lower bound creating a liquidity trap. The model suggests that bailout programs injecting capital into the corporate sector may help pushing the economy out of the trap.

Keywords: liquidity trap, financial crisis, equity capital, leverage, risk-free interest rate, bailout, heterogeneous agents, corporate finance, bankruptcy risk

JEL Classification: E32, E43, E44, E52, G12, G32