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

Listed author(s):
  • David Cook
  • Michael B. Devereux

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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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
Contact details of provider: Web page: https://www.aeaweb.org/aej-macro
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References listed on IDEAS
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  1. 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.
  2. 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.
  3. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Avoiding Liquidity Traps," CEPR Discussion Papers 2948, C.E.P.R. Discussion Papers.
  4. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
  5. Roberto Perotti, 2008. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Chapters, in: NBER Macroeconomics Annual 2007, Volume 22, pages 169-226 National Bureau of Economic Research, Inc.
  6. Troy Davig & Eric M. Leeper, 2009. "Monetary-Fiscal Policy Interactions and Fiscal Stimulus," NBER Working Papers 15133, National Bureau of Economic Research, Inc.
  7. Woodford, Michael, 2010. "Simple Analytics of the Government Expenditure Multiplier," CEPR Discussion Papers 7704, C.E.P.R. Discussion Papers.
  8. 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.
  9. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
  10. 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.
  11. 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.
  12. Ippei Fujiwara & Kozo Ueda, 2012. "The Fiscal Multiplier and Spillover in a Global Liquidity Trap," CAMA Working Papers 2012-17, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  13. 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.
  14. Fujiwara, Ippei & Nakajima, Tomoyuki & Sudo, Nao & Teranishi, Yuki, 2013. "Global liquidity trap," Journal of Monetary Economics, Elsevier, vol. 60(8), pages 936-949.
  15. 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.
  16. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1329-1368.
  17. Tommaso Monacelli & Roberto Perotti, 2008. "Fiscal Policy, Wealth Effects, and Markups," NBER Working Papers 14584, National Bureau of Economic Research, Inc.
  18. 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.
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