Monetary policy in a financial crisis

What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare? Under what conditions will a cut have the opposite effects? We answer these questions in a general class o...

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Bibliographic Details
Published inJournal of economic theory Vol. 119; no. 1; pp. 64 - 103
Main Authors Christiano, Lawrence J., Gust, Christopher, Roldos, Jorge
Format Journal Article
LanguageEnglish
Published New York Elsevier Inc 01.11.2004
Elsevier
Elsevier Science Publishing Company, Inc
SeriesJournal of Economic Theory
Subjects
Collateral constraint
Economic crisis
Economic theory
Exchange rates
Financial crisis
Interest rates
Monetary policy
Studies
E5
Exchange rates
Collateral constraint
F3
F4
Financial crisis
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Summary:What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare? Under what conditions will a cut have the opposite effects? We answer these questions in a general class of open economy models, where a financial crisis is modelled as a time when collateral constraints are suddenly binding. We find that when there are frictions in adjusting the level of output in the traded good sector and in adjusting the rate at which that output can be used in other parts of the economy, then a cut in the interest rate is most likely to result in a welfare-reducing fall in output and employment. When these frictions are absent, a cut in the interest rate improves asset positions and promotes a welfare-increasing economic expansion.
ISSN:0022-0531
1095-7235
DOI:10.1016/S0022-0531(03)00228-X