Working Paper

Liquidity Traps, Prudential Policies, and International Spillovers

Abstract: We present a simple open economy framework to study the transmission channels of monetary and macroprudential policies and evaluate the implications for international spillovers and global welfare. Using an analytical decomposition, we first identify three transmission channels: intertemporal substitution, expenditure switching, and aggregate income. Quantitatively, expenditure switching plays a prominent role for monetary policy, while macroprudential policy operates almost entirely through intertemporal substitution. Turning to the normative analysis, we show that the risk of a liquidity trap generates a monetary policy tradeoff between stabilizing output today and reducing capital flows to lower the likelihood of a future recession. However, leaning against the wind is not necessarily optimal, even in the absence of capital controls. Finally, we argue that contrary to emerging policy concerns, capital controls are not beggar-thy-neighbor and can enhance global macroeconomic stability.

Keywords: Monetary and macroprudential policies; Liquidity traps; International spillovers; Capital flows;

JEL Classification: E21; E52; F32; E62; E44; E43; E23;

https://doi.org/10.21034/wp.780

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Working Papers

Publication Date: 2021-07-27

Number: 780