DP15148 Liquidity Traps in a Monetary Union
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)).
