Financial Crisis, Equity Capital and the Liquidity Trap
40 Pages Posted: 21 Nov 2008 Last revised: 26 Jun 2009
Date Written: February 26, 2009
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
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