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Exchange rate regimes in a liquidity trap

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  • Badarau, Cristina
  • Sangaré, Ibrahima

Abstract

Using several specifications of a two-sector two-country DSGE model, this paper studies the performance of alternative exchange rate regimes in a liquidity trap caused by a large deflationary shock that pushes the nominal interest rate to its lower bound. We show that, contrary to common belief during the recent Euro crisis, the currency union can outperform the independent floating regime in dealing with the duration and depth of a liquidity trap. Although the welfare effects of the liquidity trap are conditional upon assumptions regarding export price setting and financial market structures, we find that the currency union welfare-dominates the independent floating for a plausible model with local currency pricing and incomplete asset markets. Targeting the exchange rate as a monetary policy rule allows for an independent policy to outperform the monetary union, highlighting the role of the exchange rate regime choice as a preventive strategy to address the adverse effects of deflationary and recessionary shocks.

Suggested Citation

  • Badarau, Cristina & Sangaré, Ibrahima, 2019. "Exchange rate regimes in a liquidity trap," Journal of International Money and Finance, Elsevier, vol. 93(C), pages 55-80.
    • Handle: RePEc:eee:jimfin:v:93:y:2019:i:c:p:55-80
    DOI: 10.1016/j.jimonfin.2018.12.014
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    More about this item

    Keywords

    Exchange rate regimes; Zero lower bound; Liquidity trap; DSGE;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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