Liquidity traps, capital flows

Abstract

Motivated by debates surrounding international capital flows during the Great Recession, we conduct a positive and normative analysis of capital flows when a region of the global economy experiences a liquidity trap. Capital flows reduce inefficient output fluctuations in this region by inducing exchange rate movements that reallocate expenditure towards the goods it produces. Restricting capital mobility hampers such an adjustment.From a global perspective, constrained efficiency entails subsidizing capital flows to address an aggregate demand externality associated with exchange rate movements. Absent cooperation, however, dynamic terms-of-trade manipulation motives drive countries to inefficiently restrict capital flows, impeding aggregate demand stabilization.

Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response?

“…As is well known since Cole and Obstfeld [1991] and subsequent work, in an environment with a Cobb-Douglas aggregator of domestic and imported goods (φ = 1), log consumption utility (σ = 1) and symmetric home bias, production risk is e¢ciently shared via endogenous termsof-trade movements, regardless of whether financial markets are complete or incomplete (this applies to, e.g., productivity and markup shocks). However, full risk sharing is not granted in the presence of other sources of risk directly a §ecting net foreign assets, ranging from political risk (i.e., capital controls; see, e.g., Acharya and Bengui [2016]), to shocks to financial intermediation (see, e.g., Gabaix and Maggiori [2015]) and/or preference for foreign assets (see, e.g., Cavallino…”

“…One leading answer is that the natural rate still provides a reliable compass for monetary policy: to the extent that an external deficit raises the natural rate of interest, capital inflows should be systematically matched by a tighter monetary stance (see, e.g., Obstfeld and Rogo § 2010). 1 However, this answer may not be statisfactory in the presence of financial market imperfections and nominal rigidities, whereas, as recently stressed by Farhi and Werning [2016], pecuniary and demand externalities result in capital flows and deficits that are ine¢cient (implying either over-or underborrowing), and exchange rates that are misaligned (i.e., either overvalued or undervalued). So, to the extent that monetary tightening exacerbates overvaluation, a contraction may not be the optimal policy response to a capital inflow.…”

“…Specifically, we show that, the optimal monetary policy stance in response to ine¢cient capital inflows associated with an overvalued currency and a demand boom depends on ERPT, i.e., on whether export prices are sticky in the currency of the producer (producer currency pricing or PCP) or in the currency of the importer (local currency pricing, or LCP). 3 In economies in which incomplete ERPT (due to LCP) mutes the e §ects of the exchange rate overvaluation 1 "Better macro performance comes from a monetary rule that recognizes how an external deficit raises the natural real rate of interest." Obstfeld and Rogo § [2010] p. 34.…”

“…To discuss macroeconomic dynamics, we find it analytically convenient to focus on "news shocks" (anticipation of future changes in fundamentals) as these typically generate capital flows that are excessive relative to the first best. 6 The news shocks may stem from political risk (i.e., capital controls; see, e.g., Acharya and Bengui [2016]), changes in the e¢ciency of financial intermediaries (see, e.g., Gabaix and Maggiori [2015]), changes in technology or preferences impinging on savings-without loss of generality, we focus on the latter. Notably, we show that in model specifications often adopted by the literature (see, e.g., Clarida et al 2002 and Engel 2011), capital flows in response to news shocks are exogenous to monetary policy.…”

A Contagious Malady? Open Economy Dimensions of Secular Stagnation

“…These models, including Fujiwara et al (2013), Cook and Devereux (2013), and Acharya and Bengui (2016 analyze monetary policy in a global liquidity trap and consider the implications of capital market integration. As in our model, Devereux and Yetman (2014) show that capital controls can potentially prevent the spread of liquidity traps.…”