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International economic spillovers and the liquidity trap

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  • Tarkka , Juha

    ()
    (Bank of Finland Research)

  • Kortelainen , Mika

    ()
    (Bank of Finland Research)

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    Abstract

    We study the effect of the zero bound constraint of interest rates on international transmission of eco-nomic policy and supply shocks. After some preliminary analysis with a simple theoretical model, we ap-ply a rich two-country simulation model to the problem. The model framework consists of EDGE, Bank of Finland’s dynamic equilibrium model for the euro area, linked to a similar model calibrated to resem-ble the US economy. The models have new Keynesian properties because of price rigidities and forward-looking pricing, consumption and investment behaviour. We assume freely floating exchange rates. Monetary policies are modelled with Taylor type policy rules, taking into account the zero bound con-straint for interest rates. We find that effects of policy and supply side shocks differ significantly from the ‘normal’ situation if one of the countries is in the ‘liquidity trap’, ie if the interest rate is constrained by the zero bound. Being in the liquidity trap amplifies the domestic effects of fiscal policy, but mitigates its spillover to abroad. Changing the long run inflation target, which does not have international spillovers in the normal case, does have effects abroad if the country where the target is changed is in a temporary li-quidity trap. The effects of supply shocks are also very different in the liquidity trap case compared to the normal case.

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    Bibliographic Info

    Paper provided by Bank of Finland in its series Research Discussion Papers with number 18/2005.

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    Length: 92 pages
    Date of creation: 11 Jul 2005
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2005_018

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    Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/
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    Related research

    Keywords: zero bound; liquidity trap; international spillovers; edge;

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    References

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    1. Bennett T. McCallum, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," NBER Working Papers 7677, National Bureau of Economic Research, Inc.
    2. Robert Kollmann, 2001. "Explaining international comovements of output and asset returns: the role of money and nominal rigidities," ULB Institutional Repository 2013/7632, ULB -- Universite Libre de Bruxelles.
    3. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," NBER Working Papers 10195, National Bureau of Economic Research, Inc.
    4. Coenen, Günter & Wieland, Volker, 2002. "Inflation dynamics and international linkages: a model of the United States, the euro area and Japan," Working Paper Series 0181, European Central Bank.
    5. Issing,Otmar & Gaspar,Vitor & Angeloni,Ignazio & Tristani,Oreste, 2001. "Monetary Policy in the Euro Area," Cambridge Books, Cambridge University Press, number 9780521783248, October.
    6. Robert Miguel W. K. Kollman, 1999. "Explaining International Comovements of Output and Asset Returns," IMF Working Papers 99/84, International Monetary Fund.
    7. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    8. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
    9. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    10. Kortelainen, Mika, 2002. "EDGE: a model of the euro area with applications to monetary policy," Scientific Monographs E:23/2002, Bank of Finland.
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