Sharing the Burden: Monetary and Fiscal Responses to a World Liquidity Trap

With integrated trade and financial markets, a sudden collapse in aggregate demand in a large country can cause ‘natural real interest rates’ to fall below zero in other countries, giving rise to a global ‘liquidity trap’. This paper explores the optimal policy response following such a shock, when governments cooperate on both fiscal and monetary policy. Adjusting to a large negative demand shock requires raising world aggregate demand, as well as redirecting demand towards the source (home) country. The key feature of demand shocks in a liquidity trap is that relative prices respond perversely. A negative demand shock concentrated in the home country causes an appreciation of the home terms of trade, exacerbating the slump in that country. At the zero bound, the home country cannot counter this shock. In this situation, it may be optimal for the foreign policy-maker to raise interest rates. Strikingly, the foreign country may choose to have a positive policy interest rate, even though its ‘natural real interest rate’ is below zero. An optimal policy involves a combination of relatively tight monetary policy in the foreign country combined with substantial fiscal expansion in the home country. Thus, in response to conditions generating a global liquidity trap, there is a critical mutual interaction between monetary and fiscal policy.