Global vs. Local Liquidity Traps

Abstract

This paper examines demand spillovers in a two country open economy

model to a demand shock newline (emanating from a single,

source country) sufficiently large to push one or both countries into

a liquidity trap. The zero lower bound on nominal interest rates

keeps the central bank in the source country from fully adjusting

monetary policy. We describe a two country New Keynesian model

with sufficient home bias so as to exclude symmetric movements in

response to demand shocks. We study conditions under which a

liquidity trap in one country might spillover to a trading partner. We

study, under which conditions, a liquidity trap in one country will

lead to a liquidity trap in another country. We also show conditions

under which a liquidity trap in another country can spillover into an

output expansion in a trading partner.