Working Paper: CEPR ID: DP8322
Authors: Karel Mertens; Morten O. Ravn
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.
Keywords: collateral; constraint; expectations; housing; leverage; liquidity trap
JEL Codes: E2; E3; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| loss of confidence (G41) | liquidity trap recession (E65) |
| liquidity trap recession (E65) | decline in output (E23) |
| liquidity trap recession (E65) | decline in house prices (R31) |
| high levels of leverage (G32) | amplification of output loss during liquidity traps (E19) |
| sudden deterioration in expectations (D84) | affects credit conditions (E44) |
| sudden deterioration in expectations (D84) | affects asset prices (G19) |
| high leverage + pessimistic beliefs (G41) | downward spiral in economic activity (E32) |
| credit frictions (E51) | larger output loss during liquidity traps (E19) |