Uncovering the Effects of the Zero Lower Bound with an Endogenous Financial Wedge

We study the effects of the zero lower bound (ZLB) on the severity of financial crises using an incomplete markets New Keynesian model with two occasionally binding constraints: a ZLB on the nominal interest rate and a borrowing constraint tied to an asset price. The model’s financial wedge corresponds to an endogenous multiplier on the borrowing constraint. Binding ZLB exacerbates financial crises through its interaction with the asset fire sale vicious cycle, driving up the financial wedge. Our results offer a novel reinterpretation of the negligible effect of the ZLB in representative agent New Keynesian models with exogenous wedges. (JEL E12, E31, E32, E43, E52, G01)