Persistent Liquidity Traps and Macroeconomic Policies in Open Economies

The recent years of very low or even negative interest rates represent a challenge for economic policy and economic analysis. What was expected to be a temporary period of very low interest rates has become persistent. The recent COVID shock is exacerbating this situation. Situations of liquidity traps can be analyzed in Keynesian or New Keynesian frameworks, where demand is insufficient. Macroeconomic policies in this environment are relatively well understood. However, when liquidity traps become persistent there are dimensions other than demand that become important. The objective of this project is to analyze persistent liquidity traps and the impact of macroeconomic policies in an international context. The project will emphasize the role of liquid assets in environments where some agents need liquid assets because of financial constraints. The models are non-Ricardian with agent heterogeneity. We will follow the particularly simple and tractable framework proposed by Woodford (1990}.The project is made of two subprojects that examine two different environments. The first subproject studies a two-country model where one or the two countries are in a liquidity trap. More precisely countries may hit the Effective Lower Bound (ELB) on nominal interest rates. An interesting case is the one where a creditor country is at the ELB, but not the debtor country. This could represent the Eurozone and the US in recent years. In the current situation, after the COVID shock, the two countries would be at the ELB. Several questions will be analyzed. First, what type of shocks can push countries into a persistent liquidity trap and can there be a transmission of liquidity traps across countries? Second, what is the impact of shocks and what are the channels of transmission? Third, what are the desired macroeconomic policies in each country? Part of the work could be done analytically, especially in the steady state. But the most important part has to be done through numerical simulations. This will allow us to understand the dynamics combining the more standard demand-side effects in the short run with the more persistent effects in the medium run. Also it would be interesting to use the model to understand the impact a temporary COVID shock in a low or negative interest rate environment and the appropriate policy response.The second subproject will develop a model of a small open economy receiving large capital inflows. This model is inspired by the Swiss economy, which is considered as a safe haven. A sustained period of large capital inflows can push this economy into a persistent liquidity trap. This raises important issues for monetary and fiscal policy, but it also raises theoretical questions related to the equilibrium properties and the determination of inflation. When the economy hits the ELB, the Taylor principle for monetary policy is not longer satisfied so there may be no stable solution for prices and the nominal exchange rate. On the other hand, fiscal policy may play a more important role and may allow to determine a stable equilibrium. This would change the behavior of inflation. This effect is more likely to occur in a safe haven economy where the demand for bonds is less elastic in times of turmoil. The current increase in government debt can also be taken into account. Once these issues are well understood, we can examine the impact of macroeconomic policies. As in the first subproject, the first part will be analytical and the second part will be numerical.