Financial Crashes versus liquidity trap: the dilemma of monetary policy

Gaël Giraud

Documents de travail du Centre d'Economie de la Sorbonne from Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne

Abstract: This paper considers a two-period monetary double auction with incomplete markets of securities and derivatives. Players may share heterogenous beliefs. Short positions in derivatives are constrained by collateral requirements. A central Bank stands ready to lend money or engage in unconventional monetary policy such as quantitative easing. In sharp contrast with the usual picture of equilibrium properties, I show that only three scenarios are compatible with Nash equilibrium condition: 1) either the economy enters a liquidity trap in the first period; 2) or the money injected by the Central Bank fuels a financial inflation driven by "rational exuberance", whose burst leads to a global crash in the next period, 3) else a significant inflation of commodity prices accompanies the functioning of markets. In particular, neither Friedman's golden rule, nor the Taylor rule turn out to be compatible with the third scenario: Both inevitable lead to a liquidity trap. An example shows that quantitative easing does not provide, in general, any escape from the monetary dilemma

Keywords: Central Bank; gains to trade; liquidity trap; collateral; default; crash; Taylor rule; deflation; bubble; rational exuberance; heterogenous belief (search for similar items in EconPapers)
JEL-codes: D50 E40 E44 E50 E52 E58 G38 H50 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2010-02
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http://mse.univ-paris1.fr/pub/mse/CES2010/10014.pdf (application/pdf)

Related works:
Working Paper: Financial crashes versus liquidity trap: the dilemma of monetary policy (2010)
Working Paper: Financial crashes versus liquidity trap: the dilemma of monetary policy (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:mse:cesdoc:10014

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