DP15631 Liquidity Traps in a World Economy

Author(s): Robert Kollmann
Publication Date: January 2021
Keyword(s): domestic and international shock transmission, Exchange rate, expectations-driven and fundamentals-driven liquidity traps, Net exports, 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=15631

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.