FRB: The Effects of Foreign Shocks When Interest Rates are at Zero

International Finance Discussion Papers

The Effects of Foreign Shocks When Interest Rates are at Zero
Martin Bodenstein, Christopher J. Erceg, and Luca Guerrieri
2009-983 (October 2009)

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 for policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. The duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the liquidity trap, implying more contractionary effects for the home country; conversely, large positive shocks can prompt an early exit, implying effects that are closer to those when the zero bound constraint is not binding.

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Keywords
Zero lower bound, spillover effects, DSGE models

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