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Sharing the Burden: Monetary and Fiscal Responses to a World Liquidity Trap

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  • David Cook
  • Michael B. Devereux

Abstract

This paper analyzes optimal policy responses to a global liquidity trap. The key feature of this environment is that relative prices respond perversely. A fall in demand in one country causes an appreciation of its terms of trade, exacerbating the initial shock. At the zero bound, this country cannot counter this shock. Then it may be optimal for the partner country to raise interest rates. The partner may set a positive policy interest rate, even though its “natural interest rate†is below zero. An optimal policy response requires a mutual interaction between monetary and fiscal policy.

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 5 (2013)
Issue (Month): 3 (July)
Pages: 190-228

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Handle: RePEc:aea:aejmac:v:5:y:2013:i:3:p:190-228

Note: DOI: 10.1257/mac.5.3.190
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  1. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 145-166, Fall.
  2. Beetsma, Roel & Jensen, Henrik, 2002. "Monetary and Fiscal Policy Interactions in a Micro-Funded Model of a Monetary Union," CEPR Discussion Papers 3591, C.E.P.R. Discussion Papers.
  3. Michael Woodford, 2011. "Simple Analytics of the Government Expenditure Multiplier," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(1), pages 1-35, January.
  4. Ippei Fujiwara & Kozo Ueda, 2010. "The fiscal multiplier and spillover in a global liquidity trap," Globalization and Monetary Policy Institute Working Paper 51, Federal Reserve Bank of Dallas.
  5. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Avoiding Liquidity Traps," CEPR Discussion Papers 2948, C.E.P.R. Discussion Papers.
  6. Bodenstein, Martin & Erceg, Christopher & Guerrieri, Luca, 2010. "The Effects of Foreign Shocks When Interest Rates Are at Zero," CEPR Discussion Papers 8006, C.E.P.R. Discussion Papers.
  7. Yuki Teranishi & Nao Sudo & Tomoyuki Nakajima & Ippei Fujiwara, 2013. "Global liquidity trap," AJRC Working Papers 04, Australia-Japan Research Centre, Crawford School of Public Policy, The Australian National University.
  8. John F. Cogan & Tobias Cwik & John B. Taylor & Volker Wieland, 2009. "New Keynesian versus Old Keynesian Government Spending Multipliers," NBER Working Papers 14782, National Bureau of Economic Research, Inc.
  9. Monacelli, Tommaso & Perotti, Roberto, 2008. "Fiscal Policy, Wealth Effects and Markups," CEPR Discussion Papers 7099, C.E.P.R. Discussion Papers.
  10. Troy Davig, Eric Leeper, 2009. "Monetary-Fiscal Policy Interactions And Fiscal Stimulus," Caepr Working Papers 2009-010, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  11. Cook, David & Devereux, Michael B., 2011. "Optimal fiscal policy in a world liquidity trap," European Economic Review, Elsevier, vol. 55(4), pages 443-462, May.
  12. Ester Faia & Tommaso Monacelli, 2006. "Optimal Monetary Policy in a Small Open Economy with Home Bias," Computing in Economics and Finance 2006 521, Society for Computational Economics.
  13. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2011. "When Is the Government Spending Multiplier Large?," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 78 - 121.
  14. Roberto Perotti, 2007. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Working Papers 13143, National Bureau of Economic Research, Inc.
  15. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  16. Olivier Blanchard & Roberto Perotti, 1999. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," NBER Working Papers 7269, National Bureau of Economic Research, Inc.
  17. Ippei Fujiwara & Nao Sudo & Yuki Teranishi, 2010. "The Zero Lower Bound and Monetary Policy in a Global Economy: A Simple Analytical Investigation," International Journal of Central Banking, International Journal of Central Banking, vol. 6(1), pages 103-134, March.
  18. Benigno, Gianluca & Benigno, Pierpaolo, 2006. "Designing targeting rules for international monetary policy cooperation," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 473-506, April.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Monetary and fiscal policy cooperation in a liquidity trap
    by Economic Logician in Economic Logic on 2011-10-03 14:39:00
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Cited by:
  1. Benigno, Pierpaolo & Romei, Federica, 2012. "Debt Deleveraging and the Exchange Rate," CEPR Discussion Papers 8938, C.E.P.R. Discussion Papers.
  2. Matthieu Bussière & Jean Imbs & Robert Kollmann & Romain Rancière, 2013. "The Financial Crisis: Lessons for International Macroeconomics," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 75-84, July.
  3. Michael B. Devereux & James Yetman, 2014. "Globalisation, Pass-through and the Optimal Policy Response to Exchange Rates," NBER Working Papers 20252, National Bureau of Economic Research, Inc.
  4. Luca Fornaro, 2013. "International Debt Deleveraging," Working Papers 182, Oesterreichische Nationalbank (Austrian Central Bank).
  5. Schmidt, Sebastian, 2014. "Fiscal activism and the zero nominal interest rate bound," Working Paper Series 1653, European Central Bank.

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