Research Discussion Papers, Bank of Finland
No 18/2005:
International economic spillovers and the liquidity trap
Juha Tarkka ()
and Mika Kortelainen ()
Abstract: 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.
Keywords: zero bound; liquidity trap; international spillovers; edge; (follow links to similar papers)
JEL-Codes: F42; F47; (follow links to similar papers)
92 pages, July 11, 2005
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