Exchange rate regimes in a liquidity trap

Abstract

Using several specifications of a two-sector two-country DSGE model, this paper studies the performance of alternative exchange rate regimes in a liquidity trap caused by a large deflationary shock that pushes the nominal interest rate to its lower bound. We show that, contrary to common belief during the recent Euro crisis, the currency union can outperform the independent floating regime in dealing with the duration and depth of a liquidity trap. Although the welfare effects of the liquidity trap are conditional upon assumptions regarding export price setting and financial market structures, we find that the currency union welfare-dominates the independent floating for a plausible model with local currency pricing and incomplete asset markets. Targeting the exchange rate as a monetary policy rule allows for an independent policy to outperform the monetary union, highlighting the role of the exchange rate regime choice as a preventive strategy to address the adverse effects of deflationary and recessionary shocks.