69 Pages Posted: 13 Jun 2002 Last revised: 27 Oct 2010
Date Written: June 2002
What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare? Under what conditions will a cut have the opposite e ffects? We answer these questions in a general class of open economy models, where a financial crisis is modeled as a time when collateral constraints are suddenly binding. We find that when there are frictions in adjusting the level of output in the traded good sector and in adjusting the rate at which that output can be used in other parts of the economy, then a cut in the interest rate is most likely to result in a welfare-reducing fall in output and employment. When these frictions are absent, a cut in the interest rate improves asset positions and promotes a welfare-increasing economic expansion.
Suggested Citation: Suggested Citation
Christiano, Lawrence J. and Gust, Christopher J. and Roldos, Jorge E., Monetary Policy in a Financial Crisis (June 2002). NBER Working Paper No. w9005. Available at SSRN: https://ssrn.com/abstract=316002