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81723-w19970

81723-w19970

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81723-w19970
81723-w19970

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04/05/2014

 
NBER WORKING PAPER SERIESLIQUIDITY TRAP AND EXCESSIVE LEVERAGEAnton Korinek Alp Simsek Working Paper 19970http://www.nber.org/papers/w19970NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138March 2014
The authors would like to thank Larry Ball, Ricardo Caballero, Gauti Eggertsson, Emmanuel Farhi,
Ricardo Reis, Joseph Stiglitz and seminar participants at Brown University, Harvard University, London
School of Economics, New York Fed, University of Maryland and conference participants at the 2013
SED meetings, 2013 Econometric Society Meetings, 2013 Summer Workshop of the Central Bank 
of Turkey, and the First INET Conference on Macroeconomic Externalities for helpful comments
and discussions. Korinek acknowledges financial support from INET/CIGI. The views expressed herein
are those of the authors and do not necessarily reflect the views of the National Bureau of Economic
Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peer-
reviewed or been subject to the review by the NBER Board of Directors that accompanies official
NBER publications.
© 2014 by Anton Korinek and Alp Simsek. All rights reserved. Short sections of text, not to exceed
two paragraphs, may be quoted without explicit permission provided that full credit, including © notice,
is given to the source.
 
Liquidity Trap and Excessive LeverageAnton Korinek and Alp Simsek NBER Working Paper No. 19970March 2014JEL No. E32,E44
ABSTRACT
We investigate the role of macroprudential policies in mitigating liquidity traps driven by deleveraging,
using a simple Keynesian model. When constrained agents engage in deleveraging, the interest rateneeds to fall to induce unconstrained agents to pick up the decline in aggregate demand. However,
if the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and
the economy enters a liquidity trap. In such an environment, agents' ex-ante leverage and insurance
decisions are associated with aggregate demand externalities. The competitive equilibrium allocationis constrained inefficient. Welfare can be improved by ex-ante macroprudential policies such as debt
limits and mandatory insurance requirements. The size of the required intervention depends on the
differences in marginal propensity to consume between borrowers and lenders during the deleveraging
episode. In our model, contractionary monetary policy is inferior to macroprudential policy in addressing
excessive leverage, and it can even have the unintended consequence of increasing leverage.Anton Korinek Department of EconomicsJohns Hopkins University440 Mergenthaler Hall3400 N. Charles StreetBaltimore, MD 21218and NBERakorinek@jhu.eduAlp Simsek Department of Economics, E17-244MIT77 Massachusetts AvenueCambridge, Ma. 02139and NBERasimsek@mit.edu
 
1 Introduction
Leverage has been proposed as a key contributing factor to the recent recession and theslow recovery in the US. Figure 1 illustrates the dramatic rise of leverage in the householdsector before 2008 as well as the subsequent deleveraging episode. Using county-level data,Mian and Su… (2012) have argued that household deleveraging is responsible for much of the job losses between 2007 and 2009. This view has recently been formalized in a numberof theoretical models, e.g., Hall (2011), Eggertsson and Krugman (2012), and Guerrieriand Lorenzoni (2012). These models have emphasized that the interest rate needs to fallwhen constrained agents engage in deleveraging to induce unconstrained agents to makeup for the lost aggregate demand. However, the nominal interest rate cannot fall belowzero given that hoarding cash provides an alternative to holding bonds—a phenomenonalso known as the
 liquidity trap
. When in‡ation expectations are sticky, the lower bound onthe nominal rate also prevents the real interest rate from declining, plunging the economyinto a demand-driven recession. Figure 2 illustrates that the short term nominal and realinterest rates in the US has indeed seemed constrained since December 2008.Figure 1: Evolution of household debt in the US over the last 10 years. Source: QuarterlyReport on Household Debt and Credit (August 2013), Federal Reserve Bank of New York.An important question concerns the optimal policy response to these episodes. TheUS Treasury and the Federal Reserve have responded to the recent recession by utilizing…scal stimulus and unconventional monetary policies. These policies are (at least in part)supported by a growing theoretical literature that emphasizes the bene…ts of stimulatingaggregate demand during a liquidity trap. The theoretical contributions have understand-ably taken an ex-post perspective—characterizing the optimal policy once the economy is in2

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