Time-Varying Risk Shocks and the Zero Lower Bound

This paper shows that increased volatility of Örm-level productivity can push the nominal interest rate to its lower bound with large amplification effects on macroeconomic aggregates. The framework combines a simple canonical Önancial accelerator model, time varying risk shocks, and a zero lower bound on the nominal interest rate. The amplification mechanism results from a portfolio re-balancing from households, who reduce capital investment in favor of risk-free bonds. Consequently, the capital loan volume decreases which then leads to a large decline in economic activity. We show that a substantial drop in output is accompanied by small changes in ináation. We, thus, also address the "Missing Deáation Puzzle" in the Phillips Curve literature.