Working Paper

Liquidity Traps in a Monetary Union

Abstract: The closed economy macro literature has shown that a liquidity trap can result from the self-fulfilling expectation that future inflation and output will be low (Benhabib et al. (2001)). This paper investigates expectations-driven liquidity traps in a two-country New Keynesian model of a monetary union. In the model here, country-specific productivity shocks induce synchronized responses of domestic and foreign output, while country-specific aggregate demand shocks trigger asymmetric domestic and foreign responses. A rise in government purchases in an individual country lowers GDP in the rest of the union. The results here cast doubt on the view that, in the current era of ultra-low interest rates, a rise in fiscal spending by Euro Area (EA) core countries would significantly boost GDP in the EA periphery (e.g., Blanchard et al. (2016)).

Keywords: Zero lower bound; liquidity traps; monetary unions; terms of trade; international fiscal spillovers; Euro Area;

JEL Classification: E3; E4; F2; F3; F4;

https://doi.org/10.24149/gwp397

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2020-08-25

Number: 397