Liquidity Traps and Monetary Policy: Managing a Credit Crunch,” Federal Reserve Bank of Chicago WP

We present a model of a monetary economy with heterogeneous producers and collateral constraints. We use the model to study the consequences of alternative monetary policies following a tightening in the collateral requirement. Firstly, we show that when policy does not react to the change in the environment, there is a large deflation, and a particularly severe contraction in an economy with nominal private debt. Secondly, we consider a monetary policy that implements a constant inflation target. Price stability imposes a bound on the real interest rate and it requires a sharp increase in the supply of assets by the government, moving the economy into a liquidity trap and crowding out private investment. In this case the credit crunch leads to a less pronounced recession, but slower recovery. Finally, we show that the welfare consequences of alternative monetary policies vary substantially across individuals