International Policy Spillovers at the Zero Lower Bound

Abstract

In this paper, we consider how monetary policy in a large, foreign economy affects optimal monetary policy in a small open economy ('home') in response to a large global demand shock that pushes both economies to the zero lower bound (ZLB) on nominal interest rates. We show that the inability of foreign monetary policy to stabilise the foreign economy at the ZLB creates a spillover that affects how well the home policymaker is able to stabilise its own economy. We show that more stimulatory foreign policy worsens the home policymaker's trade-off between stabilising inflation and the output gap when home and foreign goods are close substitutes. This reflects the fact that looser foreign policy leads to a relatively more appreciated home real exchange rate, which induces large expenditure switching away from home goods when goods are highly substitutable-just at a time (at the ZLB) when home policy is trying to boost demand for home goods. When goods are not close substitutes the home policymaker's ability to stabilise the economy benefits from more stimulatory foreign policy.

International Portfolio Rebalancing and Fiscal Policy Spillovers

“…To shut off the mechanism, we set all the elasticity parameters in the portfolio specification, λ a , λ S , and λ L , to infinity. Figure 3 plots the impulses for government consumption shocks only, while the corresponding figures for government investment and transfer 22 Unlike government consumption and investment shocks, we observe an increase in aggregate consumption following the transfer shock. The main reason why consumption increases following the transfer shock is because the exchange rate appreciation increases imports more in the case of the transfer shock relative to other fiscal shocks.…”

“…These results are consistent with the literature and one of the main reasons why hand-to-mouth agents are now routinely added in models considering the effects of fiscal shocks (Campbell and Mankiw, 1991). 22…”

International spillovers of forward guidance shocks

“…This model, like other open economy models, has both expenditure-augmenting and expenditure-switching forces. These two competing forces are also highlighted in studies of optimal policy and policy rules in open economies (Bodenstein et al, 2017;Fujiwara et al, 2013;Haberis and Lipinska, 2012). In theory, the net effect of international monetary policy spillovers on domestic output is ambiguous and depends crucially on the trade elasticity of substitution between domestic and foreign goods.…”

International Spillovers of Forward Guidance Shocks

“…This model, like other open economy models, has both expenditure-augmenting and expenditure-switching forces. These two competing forces are also highlighted in studies of optimal policy and policy rules in open economies (Bodenstein et al, 2017;Fujiwara et al, 2013;Haberis and Lipinska, 2012). In theory, the net effect of international monetary policy spillovers on domestic output is ambiguous and depends crucially on the trade elasticity of substitution between domestic and foreign goods.…”