Fearing the Worst and Getting the Bad

Interest rates on safe assets have trended downwards for decades. During the Great Recession many developed nations faced a liquidity trap situation as nominal interest approached the zero lower bound which obstructs the stabilization capabilities of conventional monetary policy. At the same time many economies faced sluggish recoveries from the recession. These phenomena help motivate a theoretical model in which a liquidity trap emerges as a result of a drop in the interest rate of safe assets. A simple two-period overlapping generations model is built in which young households earn income and need to save it in order to finance old-age consumption. It is assumed that there are two types of young households with different risk preferences. Risk neutral households invest in the risky asset and are able to borrow from infinitely risk averse households by supplying safe assets to them. The issuance of these safe assets is constrained by two distinct factors. Firstly, there is a financial friction in the sense that safe assets need to be backed up by collateral which ensures repayment. Secondly, the supply of safe assets is limited by the value that the lenders assign to this collateral. In the model, infinitely risk averse households fear that the collateral might drop in value. This has the effect of lowering the supply of safe assets. When fears about the future increase this has an immediate adverse effect in the present. Fears about the future drive down the safe interest rate and after a large enough rise in fears a safety trap emerges as the zero lower bound on nominal rates is met. Safety trap is a form of a liquidity trap which is caused by a decrease in the supply of safe assets. The safety trap environment features unemployment and deflation. The model economy is simulated under different scenarios in order to illustrate the mechanisms at work. In addition to this, the issuance of safe government debt and the raising of the inflation target are considered as cures for the safety trap. A rise of government debt to GDP level helps to mitigate the safety trap by increasing the supply of safe assets while a rise in the inflation target of the central bank allows the economy to reach lower real interest rates with positive nominal interest rates than before