DP8006 The Effects of Foreign Shocks When Interest Rates Are at Zero

Author(s): Martin Bodenstein, Christopher Erceg, Luca Guerrieri
Publication Date: September 2010
Keyword(s): DSGE models, spillover effects, zero lower bound
JEL(s): F32, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8006

In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound for policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. Departing from many of the existing closed-economy models, the duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the trap, implying more contractionary effects for the home country; conversely, large positive shocks can prompt an early exit, implying effects that are closer to those when the zero bound constraint is not binding.