We study a model with heterogeneous producers that face collateral and cash-in-advance constraints. These two frictions give rise to a nontrivial financial market in a monetary economy. A tightening of the collateral constraint results in a recession generated by a credit crunch. The model can be used to study the effects on the main macroeconomic variables, and on the welfare of each individual of alternative monetary and fiscal policies following the credit crunch. The model reproduces several features of the recent financial crisis, such as the persistent negative real interest rates, the prolonged period at the zero bound for the nominal interest rate, and the collapse in investment and low inflation in spite of the very large increases in liquidity adopted by the government. The policy implications are in sharp contrast to the prevalent view in most central banks, which is based on the New Keynesian explanation of the liquidity trap.

We study a model with heterogeneous producers that face collateral and cash-in-advance constraints. A tightening of the collateral constraint results in a credit-crunch-generated recession that reproduces several features of the financial crisis that unraveled in 2007 in the United States. The model can be used to study the effects of the credit-crunch on the main macroeconomic variables and the impact of alternative policies. The policy implications regarding forward guidance are in contrast with the prevalent view in most central banks, based on the New Keynesian explanation of the liquidity trap.