Monetary policy in a financial crisis

• Published in: IDEAS Working Paper Series from RePEc
• Main Authors: Christiano, Lawrence J, Gust, Christopher, Roldos, Jorge
• Format: Paper
• Language: English
• Published: St. Louis Federal Reserve Bank of St. Louis 01.01.2002
• Subjects: Economic crisis; Interest rates

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 which will it have the opposite effects? The authors answer these questions in a general class of open-economy models, modeling a financial crisis as a time when collateral constraints are suddenly binding. They find that when there are frictions in adjusting the level of output in the traded goods sector and the rate at which that output can be used in other parts of the economy, a cut in the interest rate is most likely to result in a welfare-reducing drop 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.