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The effects of foreign shocks when interest rates are at zero

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  • Martin Bodenstein
  • Christopher J. Erceg
  • Luca Guerrieri

Abstract

In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound on policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. Departing from many of the existing closed-economy models, the duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the trap, implying more contractionary effects for the home country. The home economy is more vulnerable to adverse foreign shocks if the neutral rate is lowconsistent with secular stagnationand trade openness is high.

Suggested Citation

  • Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2017. "The effects of foreign shocks when interest rates are at zero," Canadian Journal of Economics, Canadian Economics Association, vol. 50(3), pages 660-684, August.
  • Handle: RePEc:cje:issued:v:50:y:2017:i:3:p:660-684
    DOI: 10.1111/caje.12274
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    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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