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Sharing the burden: monetary and fiscal responses to a world liquidity trap

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  • Cook, David
  • Devereux, Michael B.

Abstract

With integrated trade and financial markets, a collapse in aggregate demand in a large country can cause "natural real interest rates" to fall below zero in all countries, giving rise to a global "liquidity trap." This paper explores the optimal policy response to this type of shock, when governments cooperate on both fiscal and monetary policy. Adjusting to a large negative demand shock requires raising world aggregate demand, as well as redirecting demand towards the source (home) country. ; The key feature of demand shocks in a liquidity trap is that relative prices respond perversely. A negative shock causes an appreciation of the home terms of trade, exacerbating the slump in the home country. At the zero bound, the home country cannot counter this shock. Because of this, it may be optimal for the foreign policymaker to raise interest rates. ; Strikingly, the foreign country may choose to have a positive policy interest rate, even though its natural real interest rate is below zero. A combination of relatively tight monetary policy in the foreign country combined with substantial fiscal expansion in the home country achieves the desired mix in terms of the level and composition of world expenditure. Thus, in response to conditions generating a global liquidity trap, there is a critical mutual interaction between monetary and fiscal policy.

Suggested Citation

  • Cook, David & Devereux, Michael B., 2011. "Sharing the burden: monetary and fiscal responses to a world liquidity trap," Globalization and Monetary Policy Institute Working Paper 84, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddgw:84
    Note: Published as: Cook, David and Michael B. Devereux (2013), "Sharing the Burden: Monetary and Fiscal Responses to a World Liquidity Trap," American Economic Journal: Macroeconomics 5 (3): 190-228.
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    References listed on IDEAS

    as
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Monetary and fiscal policy cooperation in a liquidity trap
      by Economic Logician in Economic Logic on 2011-10-03 19:39:00

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    Cited by:

    1. ACHARYA, Suchant & BENGUI, Julien, 2015. "Liquidity traps, capital flows," Cahiers de recherche 2015-09, Universite de Montreal, Departement de sciences economiques.
    2. Caballero, Ricardo & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2015. "Global Imbalances and Currency Wars at the ZLB," CEPR Discussion Papers 10905, C.E.P.R. Discussion Papers.
    3. Giancarlo Corsetti & Keith Kuester & Gernot J. Müller, 2017. "Fixed on Flexible: Rethinking Exchange Rate Regimes after the Great Recession," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 65(3), pages 586-632, August.
    4. Richard H. Clarida, 2017. "The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy Coordination," NBER Working Papers 23562, National Bureau of Economic Research, Inc.
    5. Gauti B. Eggertsson & Neil R. Mehrotra & Sanjay R. Singh & Lawrence H. Summers, 2016. "A Contagious Malady? Open Economy Dimensions of Secular Stagnation," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 581-634, November.
    6. David Cook & James Yetman, 2014. "Currency Boards when Interest Rates are Zero," Pacific Economic Review, Wiley Blackwell, vol. 19(1), pages 135-151, February.
    7. Matthieu Bussière & Jean Imbs & Robert Kollmann & Romain Rancière, 2013. "The Financial Crisis: Lessons for International Macroeconomics," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 75-84, July.
    8. Benigno, Pierpaolo & Romei, Federica, 2014. "Debt deleveraging and the exchange rate," Journal of International Economics, Elsevier, vol. 93(1), pages 1-16.
    9. Kuvshinov, Dmitry & Müller, Gernot J. & Wolf, Martin, 2016. "Deleveraging, deflation and depreciation in the euro area," European Economic Review, Elsevier, vol. 88(C), pages 42-66.
    10. Luca Fornaro, 2012. "International debt deleveraging," Economics Working Papers 1401, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2016.
    11. Vadym Lepetyuk & Lilia Maliar & Serguei Maliar, 2017. "Should Central Banks Worry About Nonlinearities of their Large-Scale Macroeconomic Models?," Staff Working Papers 17-21, Bank of Canada.
    12. Devereux, Michael B. & Yetman, James, 2014. "Globalisation, pass-through and the optimal policy response to exchange rates," Journal of International Money and Finance, Elsevier, vol. 49(PA), pages 104-128.
    13. Corsetti, G. & Mavroeidi, E. & Thwaites, G. & Wolf, M., 2016. "Step away from the zero lower bound: Small open economies in a world of secular stagnation," Cambridge Working Papers in Economics 1645, Faculty of Economics, University of Cambridge.
    14. Bhattarai, Saroj & Lee, Jae Won & Park, Woong Yong, 2015. "Optimal monetary policy in a currency union with interest rate spreads," Journal of International Economics, Elsevier, vol. 96(2), pages 375-397.
    15. repec:wly:jmoncb:v:49:y:2017:i:4:p:695-732 is not listed on IDEAS
    16. Sebastian Schmidt, 2017. "Fiscal Activism and the Zero Nominal Interest Rate Bound," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 49(4), pages 695-732, June.

    More about this item

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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