Liquidity Traps, Prudential Policies, and International Spillovers

Abstract We investigate optimal monetary and macroprudential policies in an open economy with aggregate demand externalities and an occasionally binding zero lower bound constraint. Our analysis highlights that the optimal policy balances output stabilization and capital flow management. When macroprudential policy is available, monetary policy stabilizes the output gap. By contrast, when macroprudential policy is not available, monetary policy is used prudentially. However, contrary to a widespread view, raising the interest rate is not necessarily the optimal prudential policy. Finally, we show that international spillovers operate through the world real rate, but macroprudential policies provide insulation from the adverse effects of foreign policies.