Dan Cao (Georgetown University) - Uncovering the Effects of Zero Lower Bound with Endogenous Financial Wedge

Dan Cao (Georgetown University) - Uncovering the Effects of Zero Lower Bound with Endogenous Financial Wedge

Co-authors: Wenland Luo (Tsinghua University) and Guangyu Nie (Shanghai University) 

Abtract
How important is the effect of the interest rate Zero Lower Bound (ZLB) on the severity of the U.S. Great Recession? We tackle this question using an incomplete markets New Keynesian model, with a ZLB on the nominal interest rate and a borrowing constraint tied to asset price. We solve the model with recurrent aggregate shocks and the two occasionally binding constraints using a novel global method. The financial wedge, which is commonly assumed to be exogenous in the existing literature, corresponds to an endogenous multiplier on the borrowing constraint and is partly driven by the binding ZLB. The binding ZLB exacerbates the financial crisis through its interaction with the Fisherian asset price deflation and asset fire-sale vicious cycles, tightening the borrowing constraint and leading to a significant increase in the financial wedge. Our results offer a novel reinterpretation of the negligible effect of ZLB in the representative agent New Keynesian models with exogenous financial wedges.

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