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

  • 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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  1. Beetsma, Roel M.W.J. & Jensen, Henrik, 2005. "Monetary and fiscal policy interactions in a micro-founded model of a monetary union," Journal of International Economics, Elsevier, vol. 67(2), pages 320-352, December.
  2. 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.
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  4. Fujiwara, Ippei & Nakajima, Tomoyuki & Sudo, Nao & Teranishi, Yuki, 2013. "Global liquidity trap," Journal of Monetary Economics, Elsevier, vol. 60(8), pages 936-949.
  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.
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  7. Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1999. "Avoiding Liquidity Traps," Working Papers 99-21, C.V. Starr Center for Applied Economics, New York University.
  8. 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.
  9. John Cogan & Tobias Cwik & John Taylor & Volker Wieland, 2009. "New Keynesian Versus Old Keynesian Government Spending Multipliers," Discussion Papers 08-030, Stanford Institute for Economic Policy Research.
  10. Michael Woodford, 2010. "Simple Analytics of the Government Expenditure Multiplier," NBER Working Papers 15714, National Bureau of Economic Research, Inc.
  11. 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.
  12. 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.
  13. Davig, Troy & Leeper, Eric M., 2009. "Monetary-Fiscal Policy Interactions and Fiscal Stimulus," CEPR Discussion Papers 7509, C.E.P.R. Discussion Papers.
  14. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
  15. 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.
  16. Tommaso Monacelli & Roberto Perotti, 2008. "Fiscal Policy, Wealth Effects, and Markups," NBER Working Papers 14584, 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. 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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