Global Imbalances and Policy Wars at the Zero Lower Bound

Abstract

This paper explores the consequences of extremely low equilibrium real interest rates in a world with integrated but heterogenous capital markets and nominal rigidities. In this context, we establish five main results: (i) Economies experiencing liquidity traps pull others into a similar situation by running current account surpluses; (ii) Reserve currencies have a tendency to bear a disproportionate share of the global liquidity trap|a phenomenon we dub the "reserve currency paradox"; (iii) While more price and wage flexibility exacerbates the risk of a deflationary global liquidity trap, it is the more rigid economies that bear the brunt of the recession; (iv) Beggar-thyneighbor exchange rate devaluations provide stimulus to the undertaking country at the expense of other countries (zero-sum); and (v) Safe public debt issuances, helicopter drops of money, and increases in government spending in any country are expansionary for all countries (positivesum). We use these results to shed light on the evolution of global imbalances, interest rates, and exchange rates since the beginning of the global financial crisis.

A Behavioral New Keynesian Model

“…Caballero offer a different explanation of the forward guidance puzzle in a model with endogenous risk premia and a shortage of safe assets (see also Caballero, Farhi and Gourinchas 2015).…”

Review of Peter Spiegler's Behind the model: a constructive critique of economic modelling. Cambridge: Cambridge University Press. 2015. 201pp.

“…Importantly, as Spiegler (p. 187) himself notes, the surveys of Marglin and Spiegler (2014) do support assumptions regarding consumption smoothing on state level. Moving away from Marglin and Spiegler (2014), some theoretical models might not be apt for the analysis of policyintervention, however, they can be fruitfully used to study the working of isolated causal mechanisms in the economy (see, for example, the Caballero et al 2015 model that introduces a mechanism for rebalancing asset markets in an economy that is at the zero-lower bound of the interest rate). I do think that shifts of epistemic aims can be pursued across different theoretical and empirical modelling exercises.…”

International Coordination

“…15 Monetary theorists shifted in a few short years from considering Keynes' liquidity trap to be an irrelevant artifact of the history of thought to considering the zero lower bound to be virtually the defining characteristic of monetary policy in the wake of the global financial crisis. 16 E.g., Chinn (2013), Engel (2014), Portes (2014), Caballero, Farhi and Gourinchas (2015), Devereux and Yetman (2014), and Landmann (2015).…”