A Tail of Three Occasionally Binding Constraints: A Modelling Approach to GDP-at-Risk

We build a semi-structural New Keynesian model to study the drivers of macroeconomic tail risk (‘GDP-at-Risk’). Our model features three key nonlinearities: an effective lower bound on nominal interest rates; a credit crunch in bank loan supply when bank capital depletes; and deleveraging by borrowers when debt service burdens become excessive. These nonlinearities can interact to amplify GDP-at-Risk: for example, when debt burdens rise sufficiently, this increases the risk of debt deleveraging but also that of a credit crunch and hitting the effective lower bound. We use the model to study various UK recessions and document the amplification potential driven by the prevailing levels of headroom vis-a-vis the effective lower bound, the bank capital constraint, and the debt service burden threshold. Furthermore, we simulate a persistent inflation shock to analyse how these interactions might operate at this juncture.