Credit Crises, Precautionary Savings, and the Liquidity Trap

This 2017 Quarterly Journal of Economics paper (circulated as NBER Working Paper 17583, November 2011) asks how an economy adjusts when households’ ability to borrow is suddenly and permanently restricted, using a Bewley-style heterogeneous-agent, incomplete-markets model in which households borrow and lend a single risk-free bond to smooth idiosyncratic income shocks. After an unexpected, permanent tightening of the borrowing limit calibrated to cut the household debt-to-GDP ratio by 10 percentage points, the paper’s first main result is that the equilibrium interest rate “overshoots”: it falls sharply and briefly turns negative for about six quarters before gradually recovering to a new, lower steady state, a pattern the authors trace to the initial wealth distribution being a mean-preserving spread of the new steady-state distribution, which temporarily creates excess desired saving concentrated among the most indebted households. The second main result is that, even with fully flexible prices, this household deleveraging and precautionary saving produces a genuine output contraction (1% on impact in the baseline calibration) rather than a pure interest-rate adjustment, because it operates partly through a misallocation channel in which poorer, borrowing-constrained workers increase labor supply while richer, unconstrained workers reduce it, lowering average productivity. When the model is extended to include nominal rigidities, the zero lower bound on the nominal interest rate can prevent the central bank from replicating the flexible-price real-rate path, making the output contraction substantially larger; and when durable goods (which can serve as collateral but are costlier to resell than bonds) are added, the size and even the direction of the durable-spending response depends on whether the credit shock hits the borrowing limit specifically (which can increase durable purchases, as unconstrained savers shift into them) or the cost of credit more broadly (which instead triggers a “flight to liquidity” and a contraction in durable spending that can become very large once fixed prices and the zero lower bound are both binding).

Guido Lorenzoni | Macro Paper Warehouse

Credit Crises, Precautionary Savings, and the Liquidity Trap