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Title: Credit Channels in a Liquidity Trap

Author(s): Karel Mertens and Morten O Ravn

Publication Date: April 2011

Keyword(s): collateral constraint, expectations, housing, leverage and liquidity trap

Programme Area(s): International Macroeconomics

Abstract: We study liquidity trap dynamics driven by nonfundamental shifts in expectations in a model with nominal rigidities, housing, credit frictions and a Taylor rule. Highly leveraged borrowing through nominal debt backed by real estate collateral greatly magnifies the decline in output and house prices during a liquidity trap recession. The amplification mechanism is much smaller when there is no feedback from house prices to the borrowing constraint, when debt is real rather nominal, and when leverage is small. We argue that the liquidity trap dynamics share some important features with the recent US recession and that high levels of leverage may have made the economy sensitive to expectations induced liquidity traps.

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Bibliographic Reference

Mertens, K and Ravn, M. 2011. 'Credit Channels in a Liquidity Trap'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8322