Credit Crises and Liquidity Constrained Households

This paper investigates how the responses of aggregate variables such as output and interest rates, subsequent a credit crisis, are conditional on the share of liquidity constrained households in a heterogeneous-agent incomplete-markets economy. As the key result, I find that both the interest rate and output under flexible prices show stronger responses in a scenario with a high share of liquidity constrained households compared to one with a lower share. Particularly, the interest rate drops further and the recession is deeper. Under a regime with nominal rigidities, the output drop is larger, because the zero lower bound prevents the nominal interest rate to replicate the flexible price allocation. Thereby, the recession with more liquidity constrained households is even more severe, and the economy is in a liquidity trap for more periods.