Working Paper: NBER ID: w9005
Authors: Lawrence J. Christiano; Christopher Gust; Jorge Roldos
Abstract: 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 e ffects? We answer these questions in a general class of open economy models, where a financial crisis is modeled 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.
Keywords: Monetary policy; Financial crisis; Interest rate cuts
JEL Codes: E5; F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Interest rate cut (E43) | welfare-reducing fall in output and employment (D69) |
| Interest rate cut (E43) | improves asset positions (G32) |
| improves asset positions (G32) | promotes economic expansion (E65) |
| Interest rate cut (E43) | exacerbates contraction (Y60) |
| Nominal interest rate cut (E43) | tighter collateral constraint (E51) |
| tighter collateral constraint (E51) | fall in external borrowing (z) (F34) |
| Presence of frictions (D59) | response of output and employment to interest rate cut is stronger (E27) |
| Frictions and substitutability between traded and nontraded goods (F12) | nature of response (contraction or expansion) (E32) |