The Fed has published an interesting working paper on the subject of foreign shocks to a country bound by zero rates. Authored by Martin Bodenstein, Christopher Erceg and Luca Guerrieri, it seems roughly to conclude that a zero-rate liquidity trap has the effect of amplifying the effects of a foreign shock on GDP.
Ongoing foreign shocks, meanwhile, can greatly extend the duration of the liquidity trap.
Here are some choice extracts (our emphasis):
The model is calibrated based on data for the United States (the home country) and an aggregate of its trading partners. A foreign demand shock that reduces foreign output by 1 percent induces U.S. GDP to fall only around 0.3 percent in normal circumstances in which U.S. short-term interest rates decline as prescribed by a standard linear Taylor rule. With the United States in a liquidity trap lasting 10 quarters (our benchmark case), the same foreign shock causes U.S. output to fall 0.7 percent.
The foreign shock has a similar contractionary effect on home exports irrespective of whether domestic monetary policy is constrained: exports fall in response to lower foreign absorption, and because lower foreign policy rates cause the home real exchange rate to appreciate. With policy rates unconstrained, the impact on home output is cushioned by a robust expansion of private domestic demand, as monetary policy responds immediately to lower demand and inflation, and real rates fall at all maturities. By contrast, because home policy rates remain frozen for some time in a liquidity trap, the fall in expected inflation pushes up short-term real interest rates, implying a much smaller expansion in domestic demand than in the unconstrained case. If the liquidity trap is sufficiently prolonged, private demand can even fall.
Critical to how exaggerated the GDP effect ends up being, write the authors, is the duration of the liquidity trap - which itself is dependent on the underlying domestic shock assumed.
If a foreign shock is small, the effect on domestic GDP is likely to be linear. However, if foreign shocks are large enough to extend the duration of the liquidity trap, their effects are likely to be non-linear - in other words much harder to predict. As they explain:
When the zero bound is not binding, increasing the trade price elasticity of demand magnifies the decline of home real net exports caused by a foreign demand contraction. However, the spillover effects on home output are partly offset by a more vigorous reaction of domestic monetary policy. By contrast, in a liquidity trap, monetary policy is unable to compensate in such a manner, and the larger effects on real net exports translate into much greater effects on home output. Consequently, they sum up:
When monetary policy is unconstrained, it can cushion the impact of foreign disturbances. By contrast, in a liquidity trap, monetary policy cannot crowd in domestic demand as effectively, and the spillover effects of foreign shocks can be magnified greatly. The amplification of idiosyncratic foreign shocks depends both on the du-ration of the liquidity trap and the size of the foreign shock, as well as on key structural features such as the trade price elasticity.And in conclusion they say the benefits of policy coordination across countries can therefore be greatly enhanced in a liquidity trap - one reason, perhaps, why policy coordination became a must in 2008 as rates headed to zero.
In which case, we wonder, what do recent rate hikes by the Australian and Norwegian central banks say about imminent US interest rate policy?
Related link:
The Effects of Foreign Shocks when Interest Rates are at Zero - Fed
