BDF paper examines international shock transmission in liquidity traps
A new Banque de France paper explores how international asset market shocks are transmitted domestically, particularly when the central bank is at the Effective Lower Bound. The research provides a new perspective on these cross-border spillovers.
Spillovers under constrained policy
The Banque de France paper develops a two-country model with non-Ricardian heterogeneous agents to analyze how asset market shocks originating abroad transmit domestically.
It specifically focuses on scenarios where the domestic central bank does not react, such as when it is at the Effective Lower Bound (ELB).
The model incorporates partially segmented international capital markets and convenience yields due to differing liquidation costs.
For instance, a permanent decline in foreign investment opportunities reduces foreign output and asset supply.
This triggers a portfolio reallocation towards home assets, potentially appreciating the home currency.
If the home central bank can lower its interest rate, it prevents appreciation, leading to an expansionary positive spillover, as seen after the 1997 Asian crisis.
However, if monetary policy is constrained at the ELB, the home currency appreciates, causing disinflation and a real interest rate increase, which can have a contractionary negative spillover.
The eurozone crisis in 2010, which decreased the supply of safe euro assets, led to portfolio shifts towards Switzerland and the US, resulting in currency appreciation, subdued inflation, and hurt growth in those economies.
The impact of spillbacks
The paper also examines 'spillbacks,' detailing the impact on the foreign economy when the home central bank does not fully accommodate a shock.
When the home country is at the ELB, various shocks cause its currency to appreciate, temporarily increasing the excess return in home currency.
This drives further capital away from the foreign country, leading to greater capital flight.
Consequently, the foreign real interest rate temporarily increases, resulting in a more significant reduction in capital accumulation and output.
The research highlights a continuum of monetary policy responses between ideal price stabilization and no response at the ELB.
In these intermediate cases, adjustment involves a mix of interest rate cuts, below-target inflation, currency appreciation, and potentially unemployment.
These findings underscore the critical role of monetary policy in shaping international spillovers.
Policy's crucial balancing act
The paper offers a crucial framework for understanding international spillovers under constrained monetary policy.
Its focus on the ELB highlights significant risks of negative transmission, challenging conventional views on financial integration.
Policymakers should consider these findings when assessing the global impact of domestic shocks and the limits of their own policy space.