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Liquidity Traps, Prudential Policies, and International Spillovers

Working Paper 780 | Published July 27, 2021

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Authors

Javier Bianchi Senior Research Economist
Louphou Coulibaly University of Wisconsin-Madison
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.