Working Paper: CEPR ID: DP8006
Authors: Martin Bodenstein; Christopher J. Erceg; Luca Guerrieri
Abstract: In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound for policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. Departing from many of the existing closed-economy models, the duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the trap, implying more contractionary effects for the home country; conversely, large positive shocks can prompt an early exit, implying effects that are closer to those when the zero bound constraint is not binding.
Keywords: Zero Lower Bound; Spillover Effects; DSGE Models
JEL Codes: F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Foreign demand shocks (F41) | Domestic output (E23) |
| Liquidity trap (E41) | Amplification of foreign demand shocks on domestic output (F41) |
| Duration of liquidity trap (E41) | Magnitude of spillover effects (F69) |
| Size of foreign shock (F41) | Magnitude of spillover effects (F69) |
| Inability to lower interest rates (E43) | Higher short-term real interest rates (E43) |
| Higher short-term real interest rates (E43) | Dampened domestic demand (D12) |