Working Paper: NBER ID: w17131
Authors: David Cook; Michael B. Devereux
Abstract: With integrated trade and financial markets, a collapse in aggregate demand in a large country can cause 'natural real interest rates' to fall below zero in all countries, giving rise to a global 'liquidity trap'. This paper explores the policy choices that maximize the joint welfare of all countries following such a shock, when governments cooperate on both fiscal and monetary policy. Adjusting to a large negative demand shock requires raising world aggregate demand, as well as redirecting demand towards the source (home) country. The key feature of demand shocks in a liquidity trap is that relative prices respond perversely. A negative shock causes an appreciation of the home terms of trade, exacerbating the slump in the home country. At the zero bound, the home country cannot counter this shock. Because of this, it may be optimal for the foreign policy-maker to raise interest rates. Strikingly, the foreign country may choose to have a positive policy interest rate, even though its 'natural real interest rate' is below zero. A combination of relatively tight monetary policy in the foreign country combined with substantial fiscal expansion in the home country achieves the level and composition of world expenditure that maximizes the joint welfare of the home and foreign country. Thus, in response to conditions generating a global liquidity trap, there is a critical mutual interaction between monetary and fiscal policy.
Keywords: liquidity trap; monetary policy; fiscal policy; aggregate demand
JEL Codes: E5; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| collapse in aggregate demand in a large country (E00) | natural real interest rates fall below zero in all countries (E43) |
| natural real interest rates fall below zero in all countries (E43) | global liquidity trap (F65) |
| tight monetary policy in the foreign country (F31) | alleviating adverse effects of the liquidity trap in the home country (F32) |
| substantial fiscal expansion in the home country (E62) | optimal policy response during global liquidity trap (E63) |
| foreign interest rate policy (E43) | home country's economic conditions (F29) |
| expansionary fiscal policies in all countries (E62) | optimal cooperative response to global liquidity trap (E61) |
| least affected country engaging in contractionary monetary policy (E52) | reorienting demand towards home country (F23) |