Which exchange rate regime provides the best protection against the unsuitable effects of a liquidity trap?

A two-sector two-country DSGE model was used to study the performance of alternative exchange rate regimes in a liquidity trap caused by a large deflationary shock. Contrary to common belief during the recent euro crisis, the current study shows that the currency union can outweigh the independent floating regime in dealing with the duration and depth of a liquidity trap. This result suggests that being member of the euro area represented an advantage rather than a drawback for countries which were most affected by the recent crisis. However, we also show that targeting the exchange rate as a monetary policy rule allows an independent policy to outperform the monetary union. This would be the best option for countries that are not concerned with a monetary union. This study clearly highlights the importance of the exchange rate regime as a preventive strategy to avoid the negative effects of deflationary and recessionary shocks.

Author: Cristina; Ibrahima , Badarau; Sangaré
Volume: 2019 2 (1)
Publisher: INFER
Year: 2019
No. of pages: 5
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