Uncovering the Effects of Zero Lower Bound with Endogenous Financial Wedge

130 Pages Posted: 12 Feb 2020 Last revised: 8 Sep 2020

See all articles by Dan Cao

Dan Cao

Georgetown University - Department of Economics

Wenlan Luo

Tsinghua University - School of Economics & Management

Guangyu Nie

Shanghai University of Finance and Economics

Date Written: February 15, 2019

Abstract

How important is the effect of the interest rate Zero Lower Bound (ZLB) on the severity of the U.S. Great Recession? We tackle this question using an incomplete markets New Keynesian model, with a ZLB on the nominal interest rate and a borrowing constraint tied to asset price. We solve the model with recurrent aggregate shocks and the two occasionally binding constraints using a novel global method. The financial wedge, which is commonly assumed to be exogenous in the existing literature, corresponds to an endogenous multiplier on the borrowing constraint and is partly driven by the binding ZLB. The binding ZLB exacerbates the financial crisis through its interaction with the Fisherian asset price deflation and asset fire-sale vicious cycles, tightening the borrowing constraint and leading to a significant increase in the financial wedge. Our results offer a novel reinterpretation of the negligible effect of ZLB in the representative agent New Keynesian models with exogenous financial wedges.

Keywords: Zero Lower Bound, Asset Fire-Sale, Global Solution

JEL Classification: C60, E20, E30, E40, E50, G11

Suggested Citation

Cao, Dan and Luo, Wenlan and Nie, Guangyu, Uncovering the Effects of Zero Lower Bound with Endogenous Financial Wedge (February 15, 2019). Available at SSRN: https://ssrn.com/abstract=3531341 or http://dx.doi.org/10.2139/ssrn.3531341

Dan Cao (Contact Author)

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States

Wenlan Luo

Tsinghua University - School of Economics & Management ( email )

Beijing, 100084
China

Guangyu Nie

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, Shanghai 200433
China

HOME PAGE: http://www.nieguangyu.wixsite.com/econ

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