Investigating the Zero Lower Bound on the Nominal Interest Rate Under Financial Instability

This paper introduces a zero lower bound constraint on the nominal interest rate in a financial accelerator model with nominal and real rigidities. We .rst analyze the implicationsfor aggregate dynamics of binding the zero lower bound for shocks that depress the nominalinterest rate. We include a sudden decrease in the value of the business sector net worth and an increase in its returns volatility, as two financial shocks that originate in the endogenous credit market of the model. We then explore the effects of the central bank management of expectations and a fiscal stimulus in a deep recession scenario, where the interest rate initially binds its zero bound. We find that a commitment by the central bank to keep the interest rate low for more time than prescribed by a typical interest rate rule may indeed reduce the volatility of output and inflation. For government purchases, we find a fiscal multiplier greater than one for at least 5 quarters. This is due to the presence of the zero lower bound and the Fisher (1933)’s debt-deflation channel, which implies that government spending may reduce the business sector risk premium and thus the cost of investment.