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International policy spillovers at the zero lower bound

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  • Haberis, Alex

    ()
    (Bank of England)

  • Lipińska, Anna

    ()
    (Federal Reserve Board)

Abstract

In this paper, we consider how monetary policy in a large, foreign economy affects optimal monetary policy in a small open economy (‘home’) in response to a large global demand shock that pushes both economies to the zero lower bound (ZLB) on nominal interest rates. We show that the inability of foreign monetary policy to stabilise the foreign economy at the ZLB creates a spillover that affects how well the home policymaker is able to stabilise its own economy. We show that more stimulatory foreign policy worsens the home policymaker’s trade-off between stabilising inflation and the output gap when home and foreign goods are close substitutes. This reflects the fact that looser foreign policy leads to a relatively more appreciated home real exchange rate, which induces large expenditure switching away from home goods when goods are highly substitutable – just at a time (at the ZLB) when home policy is trying to boost demand for home goods. When goods are not close substitutes the home policymaker’s ability to stabilise the economy benefits from more stimulatory foreign policy.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 464.

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Length: 47 pages
Date of creation: 07 Oct 2012
Date of revision:
Handle: RePEc:boe:boeewp:0464

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Keywords: Small open economy; Policy trade-offs; Trade structure; zero lower bound;

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References

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  1. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics 19950, London School of Economics and Political Science, LSE Library.
  2. Anna Lipińska & Morten Spange & Misa Tanaka, 2011. "International Spillover Effects and Monetary Policy Activism," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(8), pages 1735-1748, December.
  3. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," NBER Working Papers 10838, National Bureau of Economic Research, Inc.
  4. Coenen, Günter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Working Paper Series 0218, European Central Bank.
  5. 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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  13. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2009. "The effects of foreign shocks when interest rates are at zero," International Finance Discussion Papers 983, Board of Governors of the Federal Reserve System (U.S.).
  14. Benigno, Pierpaolo & López-Salido, David, 2002. "Inflation persistence and optimal monetary policy in the euro area," Working Paper Series 0178, European Central Bank.
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  18. Nakajima, Tomoyuki, 2008. "Liquidity trap and optimal monetary policy in open economies," Journal of the Japanese and International Economies, Elsevier, vol. 22(1), pages 1-33, March.
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Cited by:
  1. Eichengreen, Barry, 2013. "Currency war or international policy coordination?," Journal of Policy Modeling, Elsevier, vol. 35(3), pages 425-433.

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