Global vs. Local Liquidity Traps

David Cook ; Michael B. Devereux

Corresponding Author, Associate Professor, Hong Kong University of Science and Technology, Clearwater Bay, Kowloon, HKSAR, Tel: +852-2358-7614, Fax: +852-2358-2084 davcook@ust.hk
Professor, University of British Columbia, 997-1873, East Mall, Vancouver BC V6T 1Z1, Canada, Tel: +604-822-2542, Fax: +604-822-5915 devm@mail.ubc.ca

JEL Classification: E2, E5, E6

Abstract

This paper examines demand spillovers in a two country open economy model to a demand shock newline (emanating from a single, source country) sufficiently large to push one or both countries into a liquidity trap. The zero lower bound on nominal interest rates keeps the central bank in the source country from fully adjusting monetary policy. We describe a two country New Keynesian model with sufficient home bias so as to exclude symmetric movements in response to demand shocks. We study conditions under which a liquidity trap in one country might spillover to a trading partner. We study, under which conditions, a liquidity trap in one country will lead to a liquidity trap in another country. We also show conditions under which a liquidity trap in another country can spillover into an output expansion in a trading partner.

Keywords:

Liquidity trap, Monetary policy, Fiscal policy, International spillovers

Acknowledgments

Devereux thanks SSHRC, the Bank of Canada, and the Royal Bank of Canada for financial support. Cook thanks the Hong Kong Research Grants Council (UST08/09 640908). The opinions in this paper are those of the authors alone and cannot be ascribed to the Bank of Canada.

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