DP15148 Liquidity Traps in a Monetary Union

Author(s): Robert Kollmann
Publication Date: August 2020
Keyword(s): Euro Area, international fiscal spillovers, liquidity trap, monetary union, terms of trade, zero lower bound
JEL(s): E3, E4, F2, F3, F4
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15148

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 result 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)).