Financial Frictions, Liquidity Traps, and Monetary Policy

50 Pages Posted: 9 Oct 2018 Last revised: 19 Dec 2018

See all articles by Tiantian Dai

Tiantian Dai

Central University of Finance and Economics (CUFE) - China Economics and Management Academy

Chao He

East China Normal University (ECNU)

Date Written: December 19, 2018

Abstract

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

Dai, Tiantian and He, Chao, Financial Frictions, Liquidity Traps, and Monetary Policy (December 19, 2018). Available at SSRN: https://ssrn.com/abstract=3249864 or http://dx.doi.org/10.2139/ssrn.3249864

Tiantian Dai

Central University of Finance and Economics (CUFE) - China Economics and Management Academy ( email )

NO.39 South College Road
Haidian District
Beijing, 100081
China

Chao He (Contact Author)

East China Normal University (ECNU) ( email )

North Zhongshan Road Campus
3663 N. Zhongshan Rd.
Shanghai, 200062
China

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