Financial Frictions, Liquidity Traps, and Monetary Policy
50 Pages Posted: 9 Oct 2018 Last revised: 19 Dec 2018
Date Written: December 19, 2018
To better understand liquidity traps, we explicitly model open market operations and standing facilities. With financial frictions, the model is consistent with the observed liquidity traps, and the zero nominal interest rate is the worst steady-state policy. We characterize dynamic exit strategies and show novel implications on monetary policy in normal times. The central bank interventions not just swap currency for bonds, but also interact with financial frictions and create differential effects on borrowers and lenders. A lower nominal rate implies higher total liquidity but more misallocation. Policies that ignore financial frictions can lead to liquidity traps endogenously over time.
Keywords: zero nominal interest rate, open market operations, standing facilities, financial frictions, liquidity traps
JEL Classification: E31, E50, E40
Suggested Citation: Suggested Citation