What are the economic effects of an interest rate cut when an economy is in the
midst of a financial crisis? Under what conditions will a cut stimulate output and
employment, and raise welfare? Under what conditions will a cut have the opposite
effects? We answer these questions in a general class of open economy models, where a
financial crisis is modeled as a time when collateral constraints are suddenly binding.
We find that when there are frictions in adjusting the level of output in the traded good
sector and in adjusting the rate at which that output can be used in other parts of the
economy, then a cut in the interest rate is most likely to result in a welfare-reducing
fall in output and employment. When these frictions are absent, a cut in the interest
rate improves asset positions and promotes a welfare-increasing economic expansion.