Effective-Lower-Bound | Macro Paper Warehouse

Liquidity Traps, Prudential Policies, and International Spillovers

Mon, 01 Jan 0001 00:00:00 +0000

The paper develops a tractable open-economy New Keynesian model with nominal rigidities and an occasionally binding zero lower bound (ZLB) to study how monetary policy and macroprudential policy (modeled as a tax on capital flows) jointly transmit to output, capital flows, and the exchange rate, and what this implies for international spillovers and global welfare. An analytical decomposition identifies three transmission channels — intertemporal substitution, expenditure switching, and aggregate income — and the calibration finds that capital controls operate almost entirely through intertemporal substitution (about 95%), whereas expenditure switching accounts for roughly a quarter to a third of the effect of monetary policy. On the normative side, the authors show that, absent capital controls, monetary policy faces a tradeoff between stabilizing output today and curbing capital flows to lower the likelihood of a future liquidity trap, but that ’leaning against the wind’ (pre-emptively raising rates) is not necessarily optimal and can be counterproductive when tradables and non-tradables are highly substitutable. Quantitatively, adding capital controls lowers the average unemployment rate conditional on a liquidity trap from about 6% to about 1.5% and cuts the unconditional welfare cost of liquidity traps from about 0.4% to about 0.1% of permanent consumption, with an average ex-ante tax on inflows of about 0.2% and an average ex-post tax on outflows of about -0.05%. Finally, contrary to ‘currency war’ concerns, the authors argue that capital controls are not beggar-thy-neighbor: a country can use them to insulate itself from adverse foreign-policy spillovers (which operate through the world real interest rate), and coordination is beneficial only during a liquidity trap and works by stimulating rather than restricting flows. All results hold within their small-open-economy model under its calibration.

Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.

In depth

Q1. What is the model, and which policies does it study?

The paper studies an infinite-horizon small open economy with nominal rigidities and an occasionally binding zero lower bound on the nominal interest rate, in which the government has two instruments — the nominal interest rate (monetary policy) and a tax on capital flows (macroprudential policy). The economy has a tradable final good and a non-tradable good with sticky prices, and features aggregate demand externalities. The authors use this setting to ask three questions: how interrelated are the transmission channels of the two policies; how should monetary policy be used jointly with macroprudential policy; and what happens to global welfare when many countries adopt prudential policies simultaneously.

Q2. What are the three transmission channels, and how much does each matter?

An analytical decomposition (extending Kaplan, Moll and Violante 2018 and Auclert 2019 to an open economy) identifies three channels — intertemporal substitution, expenditure switching, and aggregate income — and the calibration shows monetary policy and capital controls operate through very different channels. The intertemporal substitution channel accounts for about 95% of the effect of capital controls, while expenditure switching (operating through exchange-rate depreciation that shifts demand toward non-tradables) accounts for a substantial share of the effect of monetary policy — the paper states ‘about one-third’ in its introduction and ‘about one-quarter’ in its conclusion. The expenditure-switching channel and the role of the exchange rate are what distinguish the open-economy decomposition from its closed-economy antecedents.

Q3. Do open capital markets amplify or dampen monetary policy?

Capital flows may either amplify or attenuate the output effects of monetary policy, depending on the relative sizes of the elasticity of substitution over time and the elasticity across sectors. If the intertemporal elasticity exceeds the intratemporal one, an open capital account amplifies monetary policy (a monetary expansion raises total consumption more than output, so households borrow from abroad); the result reverses when the intratemporal elasticity is larger, in which case a closed capital account produces the larger output expansion.

Q4. Is ’leaning against the wind’ the optimal prudential use of monetary policy?

Contrary to a widespread policy view, leaning against the wind is not necessarily optimal: when the elasticity of substitution across sectors is higher than across time, raising the interest rate ahead of a liquidity trap can be counterproductive. In that case a rate hike generates a large negative expenditure-switching effect and a sharp income drop while only modestly reducing consumption, so in general equilibrium it leads to capital inflows and more external debt — exacerbating the aggregate demand externality and making a future contraction more likely. The implication is that a prudential monetary policy may require lowering, not raising, the interest rate ahead of a liquidity trap.

Q5. How should monetary and macroprudential policy be combined, and how pre-emptively?

When capital controls are available, the central bank uses monetary policy to stabilize output and uses the capital-flow tax to manage flows, with the macroprudential tax on debt positive only if the ZLB is likely to bind next period; monetary policy, by contrast, must be used prudentially even when the ZLB binds only in some distant future. Because monetary policy is a blunter instrument, it has to be used more pre-emptively than capital controls. The authors also show the central bank may restrict outflows during a liquidity trap when that trap is either temporary or very severe.

Q6. What are the quantitative welfare and unemployment gains from capital controls?

Adding capital controls substantially improves macroeconomic stabilization: average unemployment conditional on a liquidity trap falls from about 6% to about 1.5%, and the unconditional welfare cost of liquidity traps falls from about 0.4% to about 0.1% of permanent consumption — more than a fourfold reduction. The average ex-ante prudential tax on inflows is about 0.2% and the average ex-post tax on outflows is about -0.05%. The authors also note that, with capital controls, liquidity traps are less frequent and less severe but — perhaps surprisingly — tend to last longer.

Q7. Are capital controls beggar-thy-neighbor, and how do international spillovers work?

The authors argue that, contrary to emerging policy concerns, capital controls are not beggar-thy-neighbor and can enhance global macroeconomic stability; international spillovers operate through the world real interest rate, and a country can use capital controls to insulate itself from adverse foreign policies. In their multi-country extension, a country can remain insulated from negative spillovers of a change in the foreign monetary stance through capital controls, which can help prevent the outbreak of a currency war.

Q8. When is international policy coordination desirable?

The authors provide conditions under which a regime of uncoordinated capital controls can dominate laissez-faire, and they find that coordination is desirable only during a liquidity trap — where, notably, it calls for stimulating capital flows rather than preventing them. This stands against the view that uncoordinated capital-control policies necessarily produce a global paradox of thrift.

Q9. How do these results differ from prior open-economy liquidity-trap models?

The paper’s more benign view of spillovers contrasts with contributions such as Caballero, Farhi and Gourinchas (2021), Eggertsson et al. (2016), and Fornaro and Romei (2019), and the authors trace the difference to two features of their model: positive liquidity and the presence of ex-post capital controls. Because goods subject to nominal rigidities are consumed only domestically, foreign policies that favor savings (lowering the world interest rate) raise demand for domestic goods through asset markets and can be stabilizing at the ZLB; and ex-post controls let the central bank actively manage flows during a trap to offset adverse spillovers.

Key concepts

aggregate demand externality : the externality (as in Schmitt-Grohe and Uribe 2016 and Farhi and Werning 2016) by which an individual agent’s borrowing raises external debt and, given nominal rigidities and the ZLB, makes the economy more vulnerable to a future demand-driven contraction; it is the market failure that prudential policy targets in this model.

expenditure switching channel : the open-economy transmission channel through which an exchange-rate depreciation makes non-tradables relatively cheaper, shifting demand toward domestically produced goods; the paper finds it accounts for a substantial share (roughly a quarter to a third) of monetary policy’s effect.

intertemporal substitution channel : the channel through which a change in the intertemporal price shifts consumption between present and future; it accounts for about 95% of the effect of capital controls in the calibration.

liquidity trap / occasionally binding ZLB : a state in which the zero lower bound on the nominal interest rate binds, so conventional monetary policy cannot stabilize output; the risk of entering such a state in the future is what makes pre-emptive prudential policy valuable here.

capital controls (prudential tax on flows) : the macroprudential instrument in the model — a tax on capital inflows (ex ante) or outflows (ex post) — used to manage the level and timing of capital flows and to insulate the economy from foreign spillovers.

beggar-thy-neighbor : a policy that improves one country’s outcomes at others’ expense; the paper argues capital controls are, contrary to common concern, not beggar-thy-neighbor in its setting and can raise global stability.

Monetary Policy and the Drifting Natural Rate of Interest

Mon, 01 Jan 0001 00:00:00 +0000

This paper analyzes how monetary policy should respond to a long-run natural interest rate that can drift permanently — following a bounded random walk with upper bound 3 percent and lower bound 0 percent — when the zero lower bound (ZLB) on nominal interest rates is a binding constraint. The central result is that the long-run neutral rate (the real policy rate consistent with stable inflation in long-run equilibrium) should fall more than one-for-one with the long-run natural rate as the latter approaches zero, because the mere risk of future ZLB episodes — even when the economy is currently away from the ZLB — imparts a persistent downward bias on inflation expectations that can only be offset by maintaining a pre-emptive expansionary bias. Quantitatively, the model implies that the neutral rate should be zero as soon as the long-run natural rate falls to 75 basis points — well above the near-zero estimates prevailing in the late 2010s — and that the ZLB would bind one-third of the time under optimal policy when the natural rate fluctuates between 0 and 3 percent. Price level targeting with a 10-basis-point upward drift closely approximates optimal commitment policy and has the advantage of not requiring knowledge of the natural rate level.

Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.

In depth

Q1. What empirical fact motivates the model?

Empirical analyses of the long-run natural rate — the real interest rate prevailing over a long-run equilibrium in which nominal rigidities are absent — consistently find that it is time-varying in a manner best described by a random walk, meaning it can drift without reverting to a constant long-run level. The paper cites Holston, Laubach, and Williams (2017), Fiorentini et al. (2018), and Hamilton et al. (2016) as the main empirical references. Holston et al. (2017) place the long-run natural rate at between 0 and 1 percent in the U.S. and possibly slightly negative in the euro area as of 2016. The paper draws one central lesson: because the natural rate is time-varying and its future level is uncertain, a model with constant natural rate will give unreliable guidance for monetary policy, especially at low natural rate levels near zero.

Q2. What is the model and what are the key equilibrium concepts?

The paper embeds a new Keynesian model in which the long-run natural rate follows a bounded random walk with upper bound 3 percent and lower bound 0 percent, calibrated to post-WWII U.S. TFP data, and studies optimal monetary policy under commitment while imposing the zero lower bound. A critical distinction separates two notions of the long-run equilibrium interest rate: the “long-run natural rate” (denoted ¯r) is the real rate that would prevail in flexible-price equilibrium, determined by fundamentals outside the central bank’s control; the “neutral rate” (r*) is the real policy rate consistent with stable inflation in the long run, which the central bank operationally targets. The two coincide in standard models with constant ¯r, but diverge in this paper because ZLB risk drives a wedge between them.

Q3. What is the main theoretical result?

Under optimal commitment, the neutral rate r should fall more than one-for-one with the long-run natural rate ¯r — that is, the central bank should maintain a negative gap (r < ¯r) that widens as ¯r falls toward zero — because permanent downward movements in ¯r make future ZLB binding episodes permanently more likely, creating a persistent downward bias on inflation expectations that requires pre-emptive accommodation even in periods when the ZLB is not currently binding.** This result contrasts with the existing literature on optimal commitment at the ZLB, which has emphasized forward guidance — the promise to maintain low rates even after the economy recovers from a ZLB episode — as the primary stabilization tool. The paper shows that forward guidance alone is not sufficient when ¯r can permanently drift lower, because each downward drift permanently raises the probability of future ZLB episodes, reducing the central bank’s scope for fulfilling future inflation promises.

Q4. What are the quantitative implications?

The model implies that the neutral rate r reaches zero when the long-run natural rate ¯r is at 75 basis points — a level that was well above the near-zero estimates of ¯r prevailing at the end of the 2010s — and that the ZLB binds one-third of the time under optimal policy when ¯r fluctuates between 0 and 3 percent.* The 75 basis-point threshold means that a central bank operating in an environment where ¯r has declined to its estimated late-2010s levels would already be constrained to a neutral rate of zero under optimal policy. The one-third ZLB frequency is higher than what would be predicted by models with constant ¯r at typical calibrations, reflecting the permanent nature of ¯r shocks and their cumulative effect on the neutral rate.

Q5. What do the adjustment dynamics look like after a negative ¯r shock?

Following a permanent reduction in ¯r, the real policy rate adjusts gradually rather than immediately — remaining temporarily above the new long-run neutral rate during the transition — implying that monetary policy is contractionary along the adjustment path and that a permanent decline in ¯r is followed by a temporary disinflation before the economy settles at the new r.* This history-dependence of optimal commitment policy means the central bank does not immediately jump to the new, lower r* after a ¯r shock; it moves gradually, making the short-run policy stance more contractionary than the long-run position. The temporary disinflation is consistent with the general principle of history-dependence of optimal policy under commitment.

Q6. What role does price level targeting play?

Price level targeting variants — particularly a rule with an optimally chosen upward drift of 10 basis points — closely approximate the economic outcomes achieved under optimal commitment policy in the model, with the practical advantage that such rules do not require the central bank to know or estimate the current level of the long-run natural rate ¯r. The Eggertsson-Woodford (2003) price level target works well in models with constant ¯r by generating positive inflation expectations in the wake of deflationary ZLB episodes. Adding a small upward drift of 10 basis points strengthens this property under a drifting ¯r, because it provides additional buffer against the downward expectations bias that permanent ¯r drift generates. Under price level targeting rules, the neutral rate reaches the ZLB as soon as ¯r falls below 1 percent.

Key concepts

long-run natural rate (¯r) : the real interest rate prevailing over a long-run equilibrium in which nominal rigidities are absent; in this paper modelled as a bounded random walk with upper bound 3 percent and lower bound 0 percent, calibrated to post-WWII TFP data.

neutral rate (r)* : the real policy rate consistent with stable inflation in the long run; distinct from ¯r in this paper because ZLB risk drives a negative gap (r* < ¯r) that widens as ¯r approaches zero.

zero lower bound (ZLB) : the constraint that nominal policy rates cannot fall below zero; in this model the reason that permanent reductions in ¯r create a persistent downward bias on inflation expectations even when the ZLB is not currently binding.

expansionary bias : the paper’s finding that optimal commitment policy should maintain r* < ¯r — a pre-emptive accommodation away from the ZLB — to offset the downward bias on inflation expectations created by the risk of future ZLB episodes.

price level targeting : a monetary policy rule in which the central bank targets the price level rather than the inflation rate; shown in this paper to approximate optimal commitment policy and to have the practical advantage of not requiring knowledge of ¯r.