DP14683 The Open-Economy ELB: Contractionary Monetary Easing and the Trilemma

Author(s): Paolo Cavallino, Damiano Sandri
Publication Date: April 2020
Keyword(s): carry trade, Collateral constraints, Currency mismatches, monetary policy, Spillovers
JEL(s): E5, F3, F42
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14683

Contrary to the trilemma, we show that international financial integration can undermine the transmission of monetary policy even in countries with flexible exchange rates due to an open-economy Effective Lower Bound. The ELB is an interest rate threshold below which monetary easing becomes contractionary due to the interaction between capital flows and collateral constraints. A tightening in global monetary and financial conditions increases the ELB and may prompt central banks to hike rates despite output contracting. We also show that the ELB gives rise to a novel inter-temporal trade-off for monetary policy and calls for supporting monetary policy with additional policy tools.