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International economic spillovers and the liquidity trap

  • Tarkka , Juha

    ()

    (Bank of Finland Research)

  • Kortelainen , Mika

    ()

    (Bank of Finland Research)

Registered author(s):

    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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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0518netti.pdf
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    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
    Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/

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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. 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.
    3. Kollmann, Robert, 2001. "Explaining international comovements of output and asset returns: The role of money and nominal rigidities," Journal of Economic Dynamics and Control, Elsevier, vol. 25(10), pages 1547-1583, October.
    4. 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.
    5. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
    6. repec:cup:cbooks:9780521783248 is not listed on IDEAS
    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. Robert Miguel W. K. Kollman, 1999. "Explaining International Comovements of Output and Asset Returns; The Role of Money and Nominal Rigidities," IMF Working Papers 99/84, International Monetary Fund.
    9. Kortelainen, Mika, 2002. "EDGE: a model of the euro area with applications to monetary policy," Scientific Monographs E:23/2002, Bank of Finland.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    11. repec:cup:cbooks:9780521788885 is not listed on IDEAS
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