Working Paper: CEPR ID: DP10905
Authors: Ricardo J. Caballero; Emmanuel Farhi; Pierre-Olivier Gourinchas
Abstract: This paper explores the consequences of extremely low equilibrium real interest rates in a world with integrated but heterogenous capital markets, and nominal rigidities. In this context, we establish five main results: (i) Economies experiencing liquidity traps pull others into a similar situation by running current account surpluses; (ii) Reserve currencies have a tendency to bear a disproportionate share of the global liquidity trap?a phenomenon we dub the "reserve currency paradox;" (iii) Beggar-thy-neighbor exchange rate devaluations stimulate the domestic domestic economy at the expense of other economies; (iv) While more price and wage flexibility exacerbates the risk of a deflationary global liquidity trap, it is the more rigid economies that bear the brunt of the recession; (v) (Safe) Public debt issuances and increases in government spending anywhere are expansionary everywhere, and more so when there is some degree of price or wage flexibility. We use our model to shed light on the evolution of global imbalances, interest rates, and exchange rates since the beginning of the global financial crisis.
Keywords: capital flows; current account; exorbitant privilege; forward guidance; inflation rate; interest rates; liquidity and safety traps; recessions; reserve currency; safe assets; secular stagnation; Taylor rule; uncovered interest parity
JEL Codes: E0; F3; F4; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| economies experiencing liquidity traps (E41) | other economies in similar situations (P19) |
| reserve currency (F31) | negative repercussions in liquidity traps (E44) |
| beggar-thy-neighbor exchange rate devaluations (F31) | stimulate domestic economies (O51) |
| beggar-thy-neighbor exchange rate devaluations (F31) | harm other economies (F69) |
| increased price and wage flexibility (F16) | risk of deflationary global liquidity trap (F65) |
| safe public debt issuances and increases in government spending (H63) | expansionary effects everywhere (F69) |