International Finance Discussion Papers International Asset Markets and Real Exchange Rate Volatility

In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound for policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. The duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the liquidity trap, implying more contractionary effects for the home country; conversely, large positive shocks can prompt an early exit, implying effects that are closer to those when the zero bound constraint is not binding.