The Effects of Foreign Shocks when Interest Rates are at Zero

RePEc Short ID: pbo319
ORCID iD: 0000-0002-4400-3719

Bodenstein, Martin; Erceg, Christopher J.; Guerrieri, Luca

doi:10.17016/IFDP.2016.983r

Working Paper

The Effects of Foreign Shocks when Interest Rates are at Zero

Abstract: In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound on policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. Departing from many of the existing closed-economy models, the duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the trap, implying more contractionary effects for the home country. The home economy is more vulnerable to adverse foreign shocks if the neutral rate is low ? consistent with \"secular stagnation\" ? and trade openness is high.

Keywords: Zero lower bound; Spillover effects; DSGE models;

JEL Classification: F32; F41;

https://doi.org/10.17016/IFDP.2016.983r