Liquidity Traps in a World Economy
53 Pages Posted: 8 Jan 2021
Date Written: January 8, 2021
This paper studies a New Keynesian model of a two-country world with a zero lower bound (ZLB) constraint for nominal interest rates. A floating exchange rate regime is assumed. The presence of the ZLB generates multiple equilibria. The two countries can experience recurrent liquidity traps induced by the self-fulfilling expectation that future inflation will be low. These “expectations-driven” liquidity traps can be synchronized or unsynchronized across countries. In an expectations-driven liquidity trap, the domestic and international transmission of persistent shocks to productivity and government purchases differs markedly from shock transmission in a “fundamentals-driven” liquidity trap.
Keywords: Zero lower bound, expectations-driven and fundamentals-driven liquidity traps, domestic and international shock transmission, terms of trade, exchange rate, net exports
JEL Classification: E3, E4, F2, F3, F4
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