Global vs. Local Liquidity Traps

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.