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The effects of foreign shocks when interest rates are at zero
Author(s) -
Bodenstein Martin,
Erceg Christopher J.,
Guerrieri Luca
Publication year - 2017
Publication title -
canadian journal of economics/revue canadienne d'économique
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.773
H-Index - 69
eISSN - 1540-5982
pISSN - 0008-4085
DOI - 10.1111/caje.12274
Subject(s) - liquidity trap , dynamic stochastic general equilibrium , economics , zero lower bound , openness to experience , monetary economics , interest rate , zero (linguistics) , duration (music) , shock (circulatory) , small open economy , market liquidity , monetary policy , international economics , liquidity risk , medicine , physics , philosophy , social psychology , psychology , linguistics , acoustics
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 on 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. The home economy is more vulnerable to adverse foreign shocks if the neutral rate is low—consistent with “secular stagnation”—and trade openness is high.