Financial Stress and Liquidity Traps

Abstract

Motivated by the bubble-collapse cycle witnessed in Japanese asset prices since the late 1980s, this paper examines how a financial crisis influences the power of monetary policy. We construct a simple macroeconomic model based on the microfoundations of Holmstrom and Tirole (1997) to analyse the effect of three types of financial stress on the nature of the equilibrium: a credit crunch; an adverse collateral shock; and a monitoring cost shock. Perhaps surprisingly, we find that the power of monetary policy is, if anything, heightened in a credit crunch; higher monitoring costs however work in the opposite direction, suggesting a need for more aggressive stabilisation policy in the face of financial shocks.