Working Paper: NBER ID: w13254
Authors: Fabio Braggion; Lawrence J. Christiano; Jorge Roldos
Abstract: In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as various real frictions wear off and the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.
Keywords: Monetary Policy; Financial Crises; Collateral Constraints
JEL Codes: E4; E44; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Immediate rise in interest rates during a crisis (E43) | Increase in economic activity (O49) |
| Immediate rise in interest rates during a crisis (E43) | Increase in welfare (I38) |
| Immediate rise in interest rates during a crisis (E43) | Introduces inefficiencies in the labor market (F66) |
| Binding collateral constraints (G33) | Immediate rise in interest rates during a crisis (E43) |
| Diminishing real frictions (F12) | Aligns monetary transmission mechanism with traditional expectations (E52) |
| Lower interest rates (E43) | Optimal monetary policy response (E63) |